Transcription
Okay, here's the scenario. You're playing in a poker game. You have the A7 of Hearts. There are two hearts on the board, so you're going for a flush draw. Your opponent bets $200. There's $400 currently in the pot. Should you call?
Hi, I'm Jack Slokum, one of the founders here at Option Alpha. If you're here for the first time in this video series, I've deposited $10,000 into a Tradier account and I'm personally trading that account, sharing what I do along the way. Winning some, losing some, learning lessons, and sharing those lessons with you. I hope you'll get something from this series.
In this video, we're going to be covering reward to risk ratio, how to use it effectively as a trader. We're going to use some poker situations to draw some parallels where it's pretty obvious what you should do and what you shouldn't do. However, many options traders don't look at their trades in this way and get into positions where the reward-risk ratio is actually not in their favor. And when you do that over a period of time, you increase the chances of you being a loser long-term.
Okay, let's jump back into this poker hand. So, nine of the 13 hearts remain, 'cause four of them are currently on the board. And we know what six of the cards are out of the total of 52. But there's 46 cards that we still haven't seen yet, counting his two cards and the rest of them in the deck. That means that out of the 46 cards that we don't know what they are, that could possibly land as the next card, nine of them are hearts. Which means 9 divided by the 46 cards, there's a 19.6% probability that the next card that comes will be a heart and will make the flush.
So now we know we have a 19.6% probability of actually hitting our flush draw. But how does that relate with these bets? And this is a similar scenario that we run into when trading. We know the probability of whether or not the trade is going to be a success. But how do we actually calculate from that probability whether or not the reward-risk ratio that we're getting actually makes this a good trade or not?
Well, there's an equation to figure that out. So this equation right here: 1 minus the probability divided by the probability, will tell you the minimum reward-risk ratio that you need in order for this to be a favorable opportunity long-term. For example, if the probability is 23.8%, then you could do the math and determine that you need at least a 320% minimum reward-risk ratio for that to be a favorable trade long-term. If the probability is up to 55%, then you would only need an 81.8% reward-risk ratio for it to be favorable long-term.
So if we jump back over into this poker hand and we look, the math from that equation works out to 410% minimum reward-to-risk ratio that we would need in order to call this bet and for it to be a good decision. However, there's $400 in the pot plus the $200 the person has bet. So we have a potential reward of $600, but we have to put in $200 to get it. Which means our reward-to-risk ratio is only 300%, and hypothetically, in this scenario, a call is actually a losing play long-term.
Relating this back to options trading, I'm going to show some examples later in this video where I placed earnings trades and I didn't even look at the reward-risk ratio versus the probability. I just made trades based on a hunch. And when I looked at those trades in retrospect, I saw the odds were actually against me, similar to calling here. And long-term, I was supposed to be a loser, and that's exactly the results I ended up with.
So if we look at this exact same hand and imagine, what if the person had bet $100? Well, now we have to call $100. So our total additional risk is $100, and we have the opportunity to win $500. What that means is we now have $500 potential reward and only $100 of potential risk. So a reward-to-risk ratio is 500%, which is higher than the 410% minimum reward-risk ratio.
As an options trader, I like to look at my trades similar to this particular hand. So let's jump on over here into Trade Ideas. First thing I'm going to do is I'm going to filter by the probability of max profit of 55% or higher. So if we jump back over here to this slide, we can see if the probability is 55% or higher, then we need an 81.8% minimum reward-to-risk ratio. So I'm going to jump back over here and I'm going to set my reward-risk ratio to 85% or higher.
The next thing I'm going to do is I'm actually going to sort by the reward-to-risk ratio. And what we have here is a whole list of potential trades that we can make that match that criteria that we looked at in the poker hand, but in the options market. So I'm going to go ahead and look and see if there's one in here that I want to trade right now. Kind of bearish on this market, so I'm looking at these QQQ short call spreads. Probability of max profit is 54%, and the reward-to-risk ratio is 104%. This one expires in 21 days.
One other thing I'd love to cover is if you look here at this payoff diagram, as long as the price stays below 444, I get to keep the max profit. But between 444 all the way to 444.51 is all of this other profit that I'm not even factoring into that equation with reward-risk ratio and probability of max profit. What that is, is all extra gravy. So when I'm trading, I'm looking for opportunities where the probability of max profit and the reward-to-risk ratio put me into a favorable position, similar to what we looked at in the poker hand. And then I also have this entire gap of profit potential right here that's just all extra. And if I can put myself into trades as frequently as possible where the overall chance of taking down the max profit has an edge, and then I have this other whole range of profit that I could potentially make as well, and I get into lots of trades like that long-term, then I feel like a good investor. I feel confident about my trades, and I feel like long-term things are going to work out.
On that note, I'm going to go ahead and place this trade and risk up to $500, like usual. And the mid-price is currently 51. I'm going to see if I go to 49, I still get 96.1% reward-risk ratio. It's looking good for me. I'm going to throw this in my manual trading bot and go ahead and make this trade. So Smart Pricing is trying to get me filled here. Hopefully, I'll get filled at a favorable price. Boom, we just got filled at 50. So I didn't actually have to go all the way down to 49. So let's see how that works out. My reward-risk is actually 100%, and my probability of max profit is 54%.
Now, this version that you're seeing here with this new payoff diagram and all of these statistics is the development version, which we're going to be pushing to production very soon. If you come in and you check out Option Alpha, it does look a little bit different. This version, the updated version, will be coming out soon. We're really excited to get it released. I expect it to land within the next week.
All right, the next thing I'm going to do is set up my exit options. So exit options are going to monitor this position. And if there's any time between now and the next 21 days when it expires where I can take 40% of the credit off the table, which imagine if once I've won 40% of that credit, my reward-risk ratio has completely changed, and I'm then risking a lot of money to win a small amount of money, in which case I want to exit that position and potentially use the same capital to get into a better position where the reward-risk ratio is once again in my favor. And I'm going to set Smart Pricing to use F prices so it gets out quickly. I'll wait at least one day to avoid pattern day trading. And boom, this position is set up.
Now, one thing I do want to cover is the options market and trading in general is not normal distribution. There's anything can happen. You know, there's binary events where the market can crash out of nowhere. There's various different scenarios that don't exist in poker. However, as a trader, what we're trying to do is bring order to chaos. Like, we're taking on risk with every options trade that we make. And any kind of data or any kind of math and probabilities that we can use to bring order to that chaos puts us in a position where we can be profitable long-term. And that's exactly what I'm trying to share with you here.
Let's take a look over here at how things are going so far. If you have been following this series, you have followed my earnings trades, which did not go very well. And I want to highlight those earnings trades as part of this video and why I believe it went wrong. So first, I placed the trade based on a hunch or limited data or my personal opinion of a company like Starbucks, not based on math and probabilities and data of any kind. Second, I stressed about the results until the reports actually came out. I was emotionally invested in the binary win-loss outcome. And when it went against me and they lost, I took it personally, and I felt like I made a bad choice. These are all things that I've learned to eliminate from my options trading experience.
The reason why I use math and probabilities like I showed you, and why I have this bot set up that's auto-trading for me, and if you look, it's winning. And the trades I've made based on math and probabilities, they're also winning. And so why is that different? Well, when I place a trade based on math and probabilities, and I feel like I'm getting in with an edge, I become much more confident about the trade I made. I set my exit options and I forget about it. I don't even look at it. Many of the times I'm working and I get a notification that one of my positions closed for a win, and I'm like, "Yes!" and I continue to work. Disconnecting emotionally from my trades is one of the most important parts to me being successful as a trader. Because when my emotions aren't invested in the trade, I don't feel compelled to go in and make another trade to try to make up for the loss I just had. Instead, I make the trade based on math and probabilities. I understand that some of them work out and some of them don't. And I'm looking at it from a long-term perspective, realizing it might take a 100 or 200 or maybe even a thousand trades for the probabilities that I'm getting in to work out in my favor. And as long as I can stay focused on that long-term outcome instead of placing options trades based on a binary event and hoping that I'm going to get lucky, the more profitable I'm going to be as a trader long-term.
I have one other thing I want to show you guys before we get off this video. I'm going to click over here to the screener. We've been doing some work on the ticker screen, and here it is. So this shows the historical range of the ticker, and this shows the expected move. Obviously, the earnings report date is in there in its visual fashion. You can click and change the time frame for the stock chart and try to predict where you believe the stock price is going to go in the future. We have all these values down here as well that you can look at. You can click here to jump straight in and potentially place a trade. There's lots of different things you can do with this new view. You can still see the existing stats, and you can look at the technicals here as well. So we're excited about this. This will be included in the new release as well.
So that's it for today's video. If you have anything that you'd like to see in future videos, please leave it in the comments. I'd love to make a video answering any questions that you have. If you got anything from this video, don't forget to like it. On behalf of the whole OA team, we love you guys. Thank you for watching, and God bless.
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