Understanding Risk Graphs & Risk to Reward Ratio
To be successful and profitable when trading options, it's vital that you control your exposure to risk, primarily to ensure that you protect your investment capital and don’t expose yourself to the possibility of losing everything. While it's ultimately necessary to take some risk in order to make profits, you should always keep it at a level you are comfortable with.
There are a number of ways that you can do this when trading options, and on this page we look at two particular ways of doing this: using risk graphs and understanding the risk to reward ratio.
What are Risk Graphs?
Risk graphs are often referred to as profit/loss diagrams. In other words, they are graphical representations of the profit or loss that you might incur on a single option position or an option spread depending on what happens to the price of the underlying security.
They are relatively simple diagrams that are made up of two axis; the vertical axis represents the profit/loss and the horizontal axis represents the price of the underlying security. The center point of the graph is usually the current price of the underlying security, and the graph line then indicates the profit or loss that a position will make according to what happens to the price of the underlying security.
The most basic graphs are as simple as that, and you could easily plot such graphs yourself. It's just a matter of working out what your profit or loss would be based on a range of the different prices of the underlying security and then compiling the graph with that information.
There's a slight flaw with these simple graphs as you may have realized. They effectively only take into account how much profit or loss you will make as the price of the underlying security moves. Options are of course affected by more than just the price of the underlying security, with factors such as time also having an effect. Despite this limitation, basic graphs still have their uses, as we explain later in this article.
Serious traders will often use detailed graphs that contain specific information to get a more precise idea about the risk profile of certain positions. While the simple graphs are easy to produce, the detailed graphs are more sophisticated and are typically produced using specialist software.
At most of the leading online brokers you will find tools for producing simple graphs, while some will also include tools for producing detailed ones too. Some online brokers will also display simplified graphs that don’t include any numbers; this shows the risk and reward profile for various well known spreads. Once you have a solid understanding of the various trading strategies, you should also be able to produce such profiles yourself.
Using Risk Graphs
Being able to use risk graphs is a valuable skill that most traders will benefit from. The main purpose of them is to illustrate the risk and reward characteristics of any particular position: whether its buying or selling a single option or combining multiple positions by using spreads. They are basically an easy way to view what the potential profits and losses of a position are likely to be, based on expectations of how the price of the underlying security will change. They are a great tool for managing risk.
For example you might you predict that, over a fixed period of time, the price of an underlying security would possibly fall by up to 5% and possibly rise by up to 10%. By looking at the risk graph of taking a specific position based on that underlying security, you could determine whether taking that position would expose you to a suitable level of risk but also have suitable potential profitability.
These graphs can also help you compare the general risk and reward profiles of different spreads and trading strategies. By studying the basic graphs associated with various strategies, you can get a solid idea of how a trade will perform depending on price movements of the underlying security. This can be a great help when you are trying to select a strategy for a particular trade and want to ensure you are comfortable with the risks involved.
If you have made forecasts about how the underlying security is likely to perform, you can compare the profiles of different strategies and select the one that suits you the best in terms of potential losses and potential profits.
Essentially, these graphs are all about making your life easier when trading options, because it can be difficult to work out how a trade will perform without carrying out a number of different calculations. By using them, it's much easier to instantly visualize and appraise the potential maximum risk and the potential profits of entering a specific trade. This can save a lot of time when deciding which trades to make, and it ultimately makes those decisions easier.
What is Risk to Reward Ratio?
The risk to reward ratio is a straightforward ratio that basically compares the anticipated returns of entering a position with the potential losses that may be incurred by entering that position. It is calculated by simply dividing the expected amount of profit by the amount of potential losses.
For example, if you bought calls worth $100 and you were expecting to be able to sell those at some point in the future for $300 then you are risking a total of $100 (if they expired worthless, then you would lose the whole $100). To potentially make $200 (if you did manage to sell them for $300). To calculate the risk to reward ratio you just divide the $200 by the $100, giving you 2. Therefore, the risk to reward ratio is 2:1.
This is something of a simplified example, because in options trading you would typically be working out the potential losses and profits of a spread rather than a single position. However, it does serve to highlight the basic principle. Working out the risk to reward ratio of a spread is not particularly difficult. It's about discovering a number of spreads' maximum profits and/or maximum losses.
The risk to reward ratio is a bit of a misnomer, because the ratio actually depicts the reward to risk. In the example above, 2 is the reward while 1 is the risk. There are some people that believe it should be referred to as the reward to risk ratio, and that risk to reward ratio is actually calculated by dividing the amount of potential losses by the amount of potential profit.
However, this is really an unnecessary complication that you don’t need to worry about. As long you know what the ratio is what it means, it doesn’t matter how you refer to it.
Using Risk to Reward Ratio
The main purpose of using this ratio is to help you make decisions about which trades to make, and most serious options traders will work out the ratio of any position before going ahead and entering that position. It is actually not that uncommon for traders to enter a position and then not make the money they expected, even if the underlying security moves as predicted, but this can be avoided by studying the ratio of potential trades first.
It's possible to gain a much clearer idea of what the expected returns of those trades are, and this can be a huge help when it comes to planning individual trades and managing the risk involved. Many options traders will set a minimum ratio, such as 4:1 for example, that must exist in order for them to enter a position.
You should always remember just how it important it is to be in control of your risk exposure when trading options. They can be very volatile financial instruments and your trades won't always work out as planned. Even if you are an experienced trader and you generally make good decisions, the market will sometimes behave in ways that you don't expect.
Because of this, you should think carefully about employing methods to control the maximum losses you are exposed to. Risk graphs and the risk to reward ratio are by no means the only tools you can use, but it's certainly useful to understand them and how they can help you.