A widely used ratio in options trading representing the expected reward per unit risk in an options trade.

Calculating Reward Risk Ratio - Introduction

Reward Risk Ratio, or sometimes known as Risk Reward Ratio, measures the amount of reward expected for every dollar risked. In fact, calculating reward risk ratio is an exercise undertaken by investment professionals around the world for every kind of trading where money and risk is involved. Reward risk ratio is calculated not only for options trading but also for stock trading, futures trading, forex trading etc. Calculating reward risk ratio is especially useful in options trading where the complexity of a position may make the relationship between risk and reward less obvious than in stock trading or futures trading.

This tutorial shall cover how to calculate reward risk ratio in options trading, why reward risk ratio is particularly interesting in options trading and how to use reward risk ratio in conjunction with your everyday trading.

Is Reward Risk Ratio and Risk Reward Ratio The Same Thing?

Incredibly, many investment advisers around the world tend to mix these two up and use them interchangably. In fact, many investment advisers would quote a reward risk ratio and call it a risk reward ratio. Yes, you must have heard options gurus say things like "You can have a 2:1 risk reward ratio using so-and-so-spread to put the odds in your favor". Well, you would know how laughable that statement is after learning about the difference between reward risk ratio and risk reward ratio.

Reward risk ratio is dividing the expected maximum profit of a trade by the expected maximum loss while risk reward ratio is the reverse, dividing expected maximum loss by the expected maximum profit. This means that a reward risk ratio produces a positive number when the potential reward exceeds the potential risk while a risk reward ratio produces a positive number when the potential risk exceeds the potential gains. This is the difference that made the above "guru statement" so funny. How can a risk reward ratio of 2:1, meaning you are risking $2 in order to make $1, be putting the odds in your favor? Yes, to this day, many investors and educators still quote reward risk ratios and call them risk reward ratio.

In options trading, we tend to stick to the reward risk ratio because it produces a number which tells us that a trade is favorable the more positive the number is.

Remember, always use the Calculating Reward Risk Ratio order when closing your naked put or call write position

Why is Calculating Reward Risk Ratio So Meaningful In Options Trading?

Calculating reward risk ratio is especially meaningful in options trading because stock options by its very nature is a convex trading instrument. A trading instrument that has convexity is a trading instrument that produces a higher potential gain than potential risk. For instance, when you buy a call option, your maximum loss is merely the amount you paid for the option, nothing more, while you stand to gain as much as the underlying stock rises, which can be many times the amount you paid for the options itself. That's convexity. Convexity prevails in many options strategies as well. For instance, most ratio spreads and bullish options strategies produces a reward risk ratio of at least 2 : 1. In fact, most options traders won't trade a position with reward risk ratio lesser than that. Indeed, 2:1 is a popular reward risk ratio that options traders use while some aggressive options traders won't trade for lesser than 4:1.

Purpose of Calculating Reward Risk Ratio in Options Trading

Calculating reward risk ratio is an exercise most serious or professional options traders do BEFORE executing a trade. Yes, this is an exercise you do before actually trading an options strategy in order to help you make a better investment decision. In fact, you would be surprised sometimes to see that the reward risk ratios of some strategies that "feels good" are actually quite unfavorable when you work out the math. Calculating the reward risk ratio of an options trade you are about to make before making it helps you avoid potentially unprofitable trades that are not immediately obvious. Many options traders also make it a policy to only trade when certain reward risk ratio has been met. Options traders with a 4:1 trading policy would work out the reward risk ratio before making a trade and makes that trade only when the reward risk ratio requirement is met in order to maximise return on investment. Yes, having a high reward risk ratio is a characteristic of options trading due to its nature as a leverage instrument.

Calculating Reward Risk Ratio

Calculating reward risk ratio for options trading is especially easy as most options strategies have pre-defined maximum profit and loss points. In fact, if you look through the options strategies tutorials here at Optiontradingpedia.com, you would see that we have included calculations for their maximum profit and loss points as well. Those are the numbers you use in calculating reward risk ratio for an options strategy you are able to execute. What you do is simply divide the maximum potential profit against the maximum potential loss to arrive at the reward risk ratio.

Calculating Reward Risk Ratio Example :

A bull call spread bounded by the strike prices $10 and $15, costs $1.50 to put on. Its maximum potential profit is $3.50 ($5 - $1.50) when the stock closes at or above $15 upon expiration and its maximum potential loss is the amount you paid for it, which is $1.50. Its reward risk ratio is:

Reward Risk Ratio = 3.50 / 1.50 = 2.3

Which means that this bull call spread has a reward risk ratio of 2.3:1.

Calculating reward risk ratio is also possible for options strategies which does not have a maximum potential profit limit. Yes, options strategies like the Straddle and the Long Call continues to profit for as long as the underlying stock moves in the favorable direction. So, how do you calculate reward risk ratio in this case? In this case, you need to decide on your outlook on how much you think the stock will move in the favorable direction and then use that as a basis for calculation. Of course, your expectation needs to be reasonable. In fact, only reasonable expectations produces consistent wins.

Calculating Reward Risk Ratio Example :

A stock is currently trading at $20 and you expect that it would rise to at least $30 by options expiration day. You bought a $20 strike price call option on this stock for $1.50. Your reward risk ratio would be:

Reward Risk Ratio = (10 - 1.50) / 1.50 = 4.4 or 4.4:1.

This means that you are making a potential $4.40 for every dollar risked in the event your expectation on the stock movement works out.

Here's another example where calculating the reward risk ratio makes a trade much much less attractive than when you first conceived it.

Calculating Reward Risk Ratio Example :

A stock is currently trading at $20 and you expect that it will breakout by $10 if a coming earnings release is favorable or fall by $10 if the coming earnings release is unfavorable. As the direction of the breakout is uncertain, you would like to make a profit no matter which direction the breakout happens and decided to use a long straddle.

The $20 strike price call option is asking at $3.00 and the put option is asking at $4.00 due to the extreme volatility surrounding this event. Your reward risk ratio is:

In this case, you are only making a potential $0.42 for each dollar risked. Does the trade still sound interesting enough to be executed?

So, how do we calculate reward risk ratio for some credit strategies which has an unlimited loss potential? These are options strategies where you would make a limited potential profit but make an unlimited potential loss. An example is the Short Straddle where you make a fixed profit through the premium of the options sold and an unlimited loss should the stock breakout. Now, nobody should be trading such options strategies without a pre-determined stop loss point. Thats right, without a stop loss point, one bad trade on such a strategy could break your bank. As such, in calculating the reward risk ratio for such options strategies, you would use the maximum loss determined by your stop loss point.

Calculating Reward Risk Ratio Example :

A stock is currently trading at $20 and you expect it to remain stagnant for the month and decided to profit from the stagnant stock using a short straddle.

The $20 strike price call option is bidding at $3.00 and the put option is bidding at $4.00 and you are using a 30% stop loss policy. Your reward risk ratio is:

Reward Risk Ratio = 7 / (7 x 0.3) = 7 / 2.1 = 3.3 or 3.3 : 1

In this case, you are making a potential $3.30 for each dollar risked.

Calculating Reward Risk Ratio - Conclusion

Yes, most options trades look good and sound good when first conceived and many beginners to options trading always have a shock only after placing a position and failing to make any money even though the stock moved as expected. By calculating the reward risk ratio of every trade before taking it allows you to make a more calculated and intelligent decision on which options strategy to use in order to make the most out of your expectations.