Calculating Risk Reward on short term optionsCalculating the risk reward on short term options is critical for your success. This ratio is the amount you would risk if you were wrong and the amount you would make if you were right. If you dont figure this number out you may find that the stock goes in your favor but the option goes against you. There are many different reasons why the option can lose value even if the stock goes in the same direction you wanted it to. One reason is the market volatility, this makes up a big part of the option price. The higher the volatility, the higher the price of the option will be. If it falls the option will be affected. It could be heading down causing the option to fall. Time value is also another reason why you can lose money on an option trade. As time passes the time value of an option will start to erode away. This is especially true for short term options which are set to expire in just a few weeks to a month. If you wanted to calculate the option risk to reward you must first understand what the bare minimum an option would be worth. This price is called the intrinsic value. It is the difference between the price of the stock and the strike price of the option. For instance, if a stock is trading at $50 the intrinsic value of the $45 call would be is $5. Knowing this can be extremely helpful. Here is how you can use it. We will say the $55 option is worth $7 for the same stock. We are expecting the stock to run up from $50 to $61. $61-$45 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 if we are right. Now say we also may want to set short term options with a stop, we will set a $4 stop on this. Meaning if the option goes down to $4 we would exit the trade only losing $4. That would give you a 2/1 risk reward ratio on the option. Which means you would make $2 if you are right and only lose $1 if you are wrong. That is also considered a good ratio to a swing trader.
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