Balancing Risk and Reward in Options

06/02/2011 10:44 am EST

Focus: OPTIONS

Kerry Given, PhD

Founder and Managing Director, Parkwood Capital LLC

Even "conservative" option strategies come with a low probability of a large loss, and Kerry Given says that understanding the risk factors and taking steps to manage them before entering a trade is crucial.

Joining me in the MoneyShow.com video network studio, Dr. Kerry Given. Kerry…I know that people look at conservative trades as one that limits their loss. What do you describe as a “conservative” options trade.

That’s a good question because people get confused, because in finance in general, you think about a “conservative” trade as being one where there’s a very low probability of any loss. 

A great example is I might buy a Treasury bond, and I might only make 3% or 4%, but I know that it’s very unlikely that I’m going to lose money, so that’s usually how we think of a conservative trade. In options trading, there’s always a probability of a loss. 

What do you think of then in terms of trading options; are you looking at the probability of success?

Exactly, a conservative trade when you’re trading options is simply one where you have a high probability of success. But we have to remember that there’s always the low probability of losing some money.

Walk me through this then; how do I identify it?

It’s really a matter of realizing the style of the trade. For example, if I have a high-probability trade, I’m likely going to have a fairly small return. I might have an 85% probability of making 10%, for example, but that means I’ve got a 15% probability of taking a loss.

Typically if I’ve got a small return, I’ve got a large loss. Even though there’s a low probability of a loss, when it happens, it’s quite large. 

You’re still comparing risk/reward ratios?

Absolutely.

The next step would be?

The other type of trade is what people call a “low-probability” trade. Some people prefer that where you have a fairly high return. 

If you’re successful, you make 500%, but the problem with that is that you have a very low probability of making that 500%. The extreme example is the lottery ticket. I buy a lottery ticket, I’m going to lose a dollar, but it’s very unlikely I’ll win.

NEXT: Strategies for "Conservative" Options Trading

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We don’t want to say that options trading is like a lottery ticket.

No, no we don’t. It’s just important that people realize that when they have a conservative options trade, which means they have a high probability of success, that there is lurking out there a low probability of a large loss. 

Let’s talk about some other strategies that you might look at in terms of conservative trading.

Basically, there’s a lot of different options trades you could trade in a conservative way. The trick, or the secret to that, is risk management. 

In every trade that you put on, there are ways to control the downside and make sure you don’t take that maximum loss that’s possible. That’s the secret of the conservative trade.

Are we talking stop-loss by dollars, stop-loss by percentage?

Well it could be a simple stop-loss. It also could be—depending on the trade—it might be some type of adjustment. 

It could be that you maybe buy a call to adjust or hedge one side of the trade. There’s a variety of adjustments that are possible. 

One of the important things to realize when you go into the trade is where I am going to make those adjustments, where am I going to stop it? Not find myself in the middle of the trade and suddenly say “It’s going against me, what am I going to do now?”

Can you use the entry and scaling in as another risk management tool?

Absolutely, that’s a very good idea. You could certainly, your entry…in fact, all of your rules about a trade, whether you enter at a particular point, how you exit, what the time line is, you may have an exit based on time,   all of that constitutes what I would call your risk management for that trade.

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