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This is part 7 of the Option Payoff Excel Tutorial. In the previous part we have learned about some very useful properties of the payoff function and calculated maximum possible profit and maximum possible loss for an option strategy options trading risk reward up to four legs. It was perhaps a bit longer and more complicated than you would have expected, as we had to make sure our calculations would correctly identify and handle the situations where maximum profit or loss could be infinite.

In this section we will use the results to calculate another very useful statistic — the options trading risk reward ratio. Risk-reward ratio, also known as reward-to-risk ratio or profit-loss ratio, is a measure that compares potential profit we can gain from a trade with the risk maximum possible loss of the trade.

Its use is not limited to options — it is also widely used with futures, forex and many other kinds of trading, business, or speculating in general.

That would be a risk-reward ratio of:. In order to make the ratio easily comparable across different trades, it is common to divide both sides by maximum loss, which makes the left side always equal to one and the right side equal to maximum profit divided by maximum loss:.

In our example, the risk-reward ratio in this format is simply 2. That said, the exact format or how we call it is not that important, as long as we understand what our number means — it means how options trading risk reward multiples of the amount at risk we can possibly gain from the trade in ideal case.

The higher the number, the better the trading opportunity, other things being equal. In our spreadsheet we will use the single number format and calculate risk-reward ratio in cell L4. As you have certainly guessed, the formula will divide maximum profit in cell L2 by maximum loss in cell L That said, loss in cell L3 is expressed as a negative number in our calculator, which would make the resulting risk-reward ratio also negative.

Firstly, for some option positions, maximum profit or maximum options trading risk reward are infinite. Secondly, options trading risk reward can be situations when all the possible outcomes from a trade are profitable maximum possible loss is in fact a profit or options trading risk reward are losses maximum possible profit is negative.

These situations can happen when you enter different legs at different times, roll over parts of your position, or in some unlikely arbitrage situations. We will address both the above mentioned types of situations by adding an IF condition to our formula. We will make the formula only return a number if the calculated maximum profit is a positive number not negative and not infinite and if the maximum loss is a negative number not positive and not infinite. As a challenge, you can expand the formula to return more specific messages when risk-reward ratio is not calculated for example: This is the end of this section.

We have expanded our spreadsheet to also calculate options trading risk reward ratio of a given option strategy. We are approaching the end of the tutorial and there options trading risk reward not much left to calculate. We will calculate break-even points there can be more than one for some strategies in the next section.

Go to next part: If you don't agree with any part of this Agreement, please leave the website now. All information is for educational purposes only and may be inaccurate, incomplete, outdated or plain wrong. Macroption is options trading risk reward liable for any damages resulting from using the content.

No financial, investment or trading advice is given at any time. Home Calculators Tutorials About Contact. Tutorial 1 Tutorial 2 Tutorial 3 Tutorial 4. What Is Risk-Reward Ratio? Format and Interpretation Risk-reward ratio can be expressed in a number of different formats, most simply as: That would be a risk-reward ratio of: Calculating Risk-Reward Ratio in Excel In our spreadsheet we will use the single number format and calculate risk-reward ratio in cell L4.

As you have certainly guessed, the formula will divide maximum profit in cell L2 by maximum loss in cell L3: The formula for risk-reward options trading risk reward in cell L4 is: Next Steps We are approaching the end of the tutorial and there is not much left to calculate.

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In all kinds of trading, we have to assess risk and potential reward on every trade. Being able to select trades that pay enough to be worth the risk is what separates the traders from the former traders and trader wannabes. In trading most instruments, the risk and reward calculations are straightforward. How many dollars do I make if the stock or futures contract or forex contract hits my target? How many do I lose if it hits my stop?

In options trading though, there are some unique challenges. Fortunately, technology gives us the tools to meet them. When we enter an option position, we are hoping to take advantage of one or more of the three forces that move option prices. All three of these forces are at work at all times on every option. They push and pull, sometimes together, sometimes against each other.

Figuring out our risk and reward requires that we take into account all of them. Here is an example. On April 24, the equity indexes were trying to decide whether to break to the downside or not.

It seemed, for a variety of reasons, that that had a pretty good chance of happening. If it did, bearish trades would work out. That day Allegheny Technology ATI showed up on a scan for stocks at the lower end of their recent range of implied volatility. Below is the chart:. Its implied volatility, at This looked like an opportunity for buying put options.

Our choices were July or October, so we focused on October. By buying options with a lot of time to go, and planning to sell them while they still had a lot of time to go, we would minimize the effect of time decay.

With our entry, stop and target prices worked out, the next step was to calculate potential reward and risk. There is no substitute for it. The magenta line is as of two months in the future, on June The reason for plotting the curve as of June 25 is to take into account the time decay that will occur in the two months we plan to hold the options.

This demonstrates that using options far out in the future results in very little time decay in the early days of their lives. This is marginal at best. We prefer a reward to risk ratio of 3 to 1 or better. Before we pass on this trade though, we need to take volatility into account. If it did come to pass that this stock dropped substantially, we would expect implied volatility to rise. We looked at this stock in the first place because it appeared on a scan for stocks at their volatility low points.

This is a much better proposition. Close but no cigar. In summary, we examined a proposed trade that had possibilities as a bearish bet on a stock at a major resistance level. We took into account the likely amount of a drop in the stock price, compared to the distance from the current price to the resistance level.

In terms of the stock price alone, the ratio seemed favorable. Next we estimated the time frame in which that drop could be expected to happen. Finally, we factored in the estimated effect of a likely increase in implied volatility.

With that done, we could get a good reading of the best-case reward vs the worst-case risk. In the end, the trade was marginal, so we passed this time. Without doing the full analysis, we might well have taken a trade that would be a poor use of our funds. Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk.

The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter.

Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.