Many traders look for trades that provide at least twice as much potential reward as the amount of risk they took. This 2:1 reward-to-risk ratio evaluation is an effective way to both look for attractive profits as well as minimize your downside risk. This evaluation applies to options trading as well as to stock trading. When you are using call options as a way to leverage long opportunities in a stock, your reward-to-risk analysis will be simplified if you use the stock rather than the option. Looking for the 2:1 reward-to-risk ratio works equally well in options trading. It can provide you with opportunities to take significant profits while still limiting your loss to a relatively low amount, even on an option trade.
Perhaps the best aspect of using reward-to-risk ratios in any kind of trading is that it provides a thorough view of all of the possibilities for what the stock could do. Identifying your potential reward usually means evaluating the range between the most current support and the closest resistance levels. If the stock goes up to the top of this range, you will have an opportunity to take your profits. On the other hand, if the trade simply doesn’t work, it will probably drop below the current support; if it does, your reward-to-risk analysis will have identified the stop-loss point at which you will get out.
The one aspect of options trading that affects reward-to-risk ratios differently than in stock trading is time decay. Since a stock won’t expire, you don’t have to worry about whether the stock moves the way you want quickly; you simply stay in the play until it goes the way you want or you get stopped out. This isn’t always true in
71 options trading. If you have purchased a relatively short period of
time, you will be facing a significant loss if the stock doesn’t move in your favor very quickly. Even if you buy what would ordinarily be a sufficient amount of time, the stock may not move in your favor in the time you have. Time decay alone can add up to a net loss in an options trade if the stock moves against you or simply doesn’t move at all. For this reason, you should carefully consider the effect of time decay in each of your option trades.
Measuring time decay can be a difficult proposition if we try to do it ourselves.
The following is a binomial table showing the damage theta can cause if a stock does not go in the direction of the trade. For this example, we’ll use a call play. As you can see from Figure 3.4, holding a call option position when the stock is staying flat is not a safe harbor.
Figure 3.4
If the stock stays at $30 a share and the option has 60 days prior to expiration, the decay factor, theta, breaks down like this:
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• 1st day of purchase-no decay
• In the first 15 days, the option value falls from $1.53 to
$1.30 for a decay of 15%
• In the next 15 days, the option value falls to $1.028 for cumulative decay of 33%
• In the next 15 days, the option value falls to $.67 for a cumulative decay of 56%
• In the final 15 days, the option value falls to $.0 for a cumulative decay of 100%
As you can see, theta accelerates as time passes.
With respect to theta, if the stock is staying relatively flat for a pro-tracted period of time, get out. Staying in only makes matters worse.
The deeper in-the-money or out-of-the money an option is, the smaller the effect time decay has on the contract. How much
higher or lower the theta will be tomorrow is something that we can’t evaluate with the information at hand since forecasting future price movement is, ultimately, little more than a “best guess” venture. The main point you need to take from looking at theta is to get a ballpark sense for how time decay is likely to affect your option. Don’t use it as a precise measurement of exactly what time decay is going to do.
Think of theta as an added cost you will have to incur no matter what contract you choose, and that the move made by the stock underlying your option must offset. This added cost should be considered as part of the risk portion of your reward-to-risk ratio in any given option trade. When you analyze reward-to-risk ratios, you should make sure that the target price your exit analysis gives you is enough to offset your time decay risk as well as the downside risk identified by your stop analysis. You should also combine your evaluation of theta with your analysis of how long you think it will take the stock to move the way you want. If you forecast a three-to-four month time period for your stock to move and plan to purchase a five-month option, for example, make sure to evaluate the theta value for that five-month option.
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