Concept #1: Risk Reward
I’ve taught options to thousands of investors over many years. And over the years, I’ve realized there was something very important missing in the process. In everyone’s process.
You’re supposed to stretch before working out.
Practice before you play.
Before learning options, you need a warm-up session.
I’ve come up with 7 concepts you need to know before learning about options.
What will this learning exercise do for you?
It’ll prepare you for what’s to come. It will help you to better understand how options work. And amazingly, it drastically cuts down the time you’ll need to absorb future lessons.
While some of these concepts may seem trivial, “obvious”, or “too easy,” I assure you they’ll make all the difference when you start to learn about options.
CONCEPT #1: Risk – Reward
Whether with investments or daily activities, we often refer to the risk reward concept when making a decision. It’s fairly simple to understand. You want to make sure that the reward compensates you for the risk your taking.
Here’s a real life example you may encounter:
If you’re trying to get to work at point B and you start here at point A, then which route would you take – C or D?
Your time has value. So by assessing the differences in time to your destination, C looks like the best choice. But what if I told you that C was a very dangerous path. Now, which would you choose?
This is where you would have to assess how dangerous the path is or how much is at risk, and whether or not that risk outweighs the extra 15 minutes you would need with D.
With stocks, it’s slightly easier because we can use actual values. Value #1 is the distance to your target stock price. And the best investors place equal focus on the amount they could lose: Value #2.
Value #1 is your reward, while Value #2 is your Risk.
Consider this example. You think a stock can go up $4 if your right or down $3 if your wrong. Assuming an equal probability for each outcome, it appears that it may be a reasonable trade idea.
But what if you can turn the risk reward analysis on the same stock into this, where you risk only $1 instead of $3 and make $3 if you’re right?
Which risk reward set up would you choose: A or B?
B should look much more enticing. Let’s try to understand why.
In each scenario, let’s create a ratio between the outcomes and normalize the risk to $1. That way we can compare the two scenarios A vs B.
In scenario A, we get $4 reward to $3 risk. To normalize it to $1 of risk, we would divide both sides by the risk amount, in this case 3.
That’s 4 divided by 3 on the Reward side, and 3 divided by 3 on the Risk side.
This would give us $1.33 reward for every $1 of risk.
Scenario B would be $3 reward for every $1 of risk. No calculation is needed here because it happens to be already at $1 of risk.
Comparing A vs. B, B offers a greater reward for the same $1 of risk. That’s why B is a better choice.
Trying to compare two examples of risk reward
Turning scenario A into B is possible using options. Your job as an investor or trader will be to know how AND when to do it.