Wednesday, July 23, 2008

Calculating Risk Reward on short term options

It is very important to calculate the risk reward on short term options. This is the amount you would risk if you were wrong and the amount you would make if you were right. If you don’t figure this number out you may find that the stock may go in your favor but the option goes against you.

There are many reasons why the option can lose value if the stock goes in the same direction you are predicting. The market volatility could be heading down causing the option to fall. Volatility makes up a big part of the option. The higher the volatility, the higher the price of the option will be. If it falls the option will be affected.

Time value can also be a reason why you can lose money on options. As time passes the time value of an option will start to erode. This is especially true for short term options which are set to expire in just a few weeks.

If you wanted to calculate the option risk to reward you must first understand that the bare minimum an option would be worth is called the intrinsic value. This is the difference between the stock price and the strike price of the option.

For instance, if a stock is trading at $40 the intrinsic value or the bare minimum that the $35 call would be worth is $5. Knowing this can be extremely helpful. Here is how you can use it.

We will say the $35 option is worth $8 for the same stock. We are expecting the stock to run up from $40 to $51. $51-$35 is $16 making the option at least worth $16 if we are right. In this case the reward for this trade would be at least $16-$8 or $8.

Now say we wanted to set the option with a $4 stop. This means if the option goes down to $4 we would exit the trade. That would give you a 2/1 risk reward ratio on the stock. Which means you would make $2 if you are right and only lose $1 if you are wrong.

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