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Risk Versus Reward Profile
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You can have a high degree of confidence in a stock but still make a bad trade because your risk/reward profile is out of whack.
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Consider a stock that jumps after releasing some bullish news. Perhaps it reported big revenue and earnings beats and management raised its guidance. Analysts increased their price targets, and suddenly the whole market wanted to own the stock.
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You might think the stock has further to run. But that doesn’t automatically make buying it a good trade.
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After the initial jump, much of the good news could already be reflected in the price. Momentum indicators could show that it’s overbought. And investors who owned the stock prior to earnings might want to lock in their profits.
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So what happens if buyers’ enthusiasm quickly fades, leading to a sharp pullback? You could effectively be risking $2 for every $1 of potential profit.
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That’s not the kind of trade I’m interested in, regardless of how confident I am about the company. Instead, I want the opposite. I want trades where the potential reward is significantly greater than the amount I’m prepared to lose. If I can risk $1 to potentially make $2 or $3, suddenly the math starts working much more in my favor.
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Structure the Trade Around Risk
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One of the reasons I use options so extensively is that I know my maximum risk up front. If I buy an option, the most I can lose is the premium I paid.
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I often look to buy options around the $3 level, which equates to $300 (an option contract is for 100 shares). If the trade doesn’t work, my loss is capped at $300. But if the move comes off, that same option could return double- or triple-digit gains.
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So I’m risking a relatively small, fixed amount to chase a much larger payday. That’s the asymmetry I’m after.
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Buying the stock outright doesn’t give me that. At $100 a share, 100 shares would tie up $10,000 – and my potential loss is far greater than a few hundred bucks.
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If I can consistently structure trades where my potential gains outweigh my potential losses, every trade doesn’t need to be a winner. A small number of strong winners can compensate for a larger number of relatively smaller losses.
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To be clear, this doesn’t mean that all option trades are good trades. You can still overpay for an option or pick the wrong strike price and expiration. Repeatedly buying call options in a strong downtrend is a surefire way to lose money. Time decay, implied volatility, and other factors all matter too.
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But if you can combine high conviction in a stock’s direction with a strong risk/reward profile, you put the odds far more in your favor.
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And in increasingly volatile markets, that could make the difference in finishing the year in the green.
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Happy Trading,
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Larry Benedict
Editor, Trading With Larry Benedict
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