Please clear my doubt :- How risk & reward is calculated for Option contracts?
Generally, max 10% of premium must be your stop loss, target minimum 1:3 for options buying…
Otherwise in the long run you will blow up your account.
Keep Trailing your stop loss …
Thanks Mr.Nidlal. Yes, you are right. I too have read Zerodhas blog on setting stop loss with GTT at 10% of decline in value of premium etc., etc. for Call index buying. Further elaborating, could you please enlighten me on the following? (i) How do you calculate risk to reward ratio 1:3 when maximum risk to buyer is premium paid and reward is unlimited. Opposite to it, sellers reward is premium received and risk is unlimited. How will you quantify in absolute number unlimited risk and unlimited reward to call seller & buyer respectively like 1:3? 1:3 is OK for individual stock and not for option.
(ii) Further, If I wish to set volatility based stop loss, what is the method to calculate it?
(iii) Will you please explain risk to reward in respect of Put option?
Thanks.
For eg. you purchased 17200 CE at 100 Rs. Then your SL must be 85 Rs., and target 145. Achieving 1:3 target will not be possible on days when market is sideways, and mostly theta decay will kick in and hit your SL even if the market doesn’t fall but remains in the same range after purchasing CE.
In option buying, if you don’t play with strict SL, on long run you will definitely blow up your account (i have experienced it myself by buying options and holding it with a hope that the price will reverse and atleast come near to my buy price)
Once you buy the call option and say it reaches 1:1 R:R (115 Rs. in the above example), you can trail your SL to your buy price (i.e. 100Rs) . Again when prices move in your favour say upto 1:2 (Rs. 130) , then you can further trail such that atleast you will get 1:1 profit (Rs. 115) and not exit the trade in loss.
In my experience, option buying needs high level skills, quick executive and fast exit so practice with 1 lot… and no buying options everyday…
Thanks Mr. Nidal. Good that you are responding smart. Your response has, however, raised few more queries and do not crack my vital doubt. Please read ahead.
(i) Your risk to reward ratio 1:3 is apparently wrong if calculated as under:-
With stop loss @ 85, Risk is 100—85=15 & Reward is 145 (target) –85=60, so RR is 15/60 , i.e, 1:4
Please see in the above example that (i) there is no holding period meaning the above RR will change according to no.of days trade is held. OK assuming that since we have set flat 15% SL, holding period does not matter. But how do you rest satisfied with setting SL @ 15% when option`s price change drastically due to high volatility and because of this, your SL is likely to get knocked down early, thereby missing your chance of profiting more later when volatility cools.
(ii) Note what we have debated above is all about when we are trading on premium before expiration. My query is about how do you calculate risk to reward when option is held till expiration, especially Put option. Mr. Nidal. There is a point in my asking about RR on Put option, because Zerodha has introduced some features on it on Call index buying and not on selling, leave alone Put option.
Hope you are clear about what I want to know. Regards.
I am not an expert on Risk / Reward but weather it is Options / futures / Cash / Commodities I believe :-
You can always define Risk and you should define it , But if you predetermine reward its not going to work in long run, you should enter position and let the market decide the reward.
It has to be something which can take care of you losses that’s why you always hear - Let your profits run
Now the problem with Option Buying is that once a big move is completed it takes Time to consolidate before direction can be determined and as a option Buyer Time is Blood the more you wait without momentum more you bleed, I suppose that’s why this point came up , So to gauge momentum you have to spend time with candles and that’s the only way ( Price action only no indicators etc.)