Hi all - long time listener, first time advise seeker. Let's say I have $360 and I'm a little bullish on google. I'd like to buy a 550 call and sell a 560 call. The difference between the two is 350 - and with 10 commissions I'm @ 360 on the dot. My max profit is $1000 - 360 = $640 My max loss is $360. When thinking about risk vs reward I think of this like a 1.7 (or less than 2 times risk reward). Does anyone out there have hard and fast rules about what that multiple should look like? Does this seem like a foolish trade? If so, why? thx, dave
One flaw is that you're assuming an equal probability of realizing the maximum gain and maximum loss. Because of that, the multiple is "arbitrary".
Sure - life never works in maximums and minimums, just increments in between. That said, those are the only two variables I'm getting my head around right now. What I'm really looking for is any thoughts on a) what could kill me from left field or b) advice on a better trade that's like this with less risk and more reward .
There are no hard and fast rules. The further OTM you go the greater the reward relative to risk, however the probability of the stock reaching that level is lower. So it's a trade off, higher reward to risk multiple and lower probability, or lower reward to risk and higher probability.
To mitigate risk in directional call buying, I focus on stocks in clear uptrends in markets in up trends. Right now, stock market is in a consolidation (or correction) phase so directional call buying has to be done with extreme care or just avoided all together. IMHO, the easiest directional call entry is on a pull back in an uptrending stock in an uptrending market. I'd be a patient waiter right now for that kind of trade.
Some folks base their reward:risk ratio not on max risk but on some fraction of it. i.e. you'd never let it go to max risk but have a mental stop of maybe 1/2.
Look at buying spreads that get you net short premium. That will give you a static yield and a downside buffer. It will also increase a log-normal distribution probability (which I don't give too much weight to - as I personally believe options pricing models are flawed by their very nature of probability expectations - which does not consider the skew curve - but that is another story.)
Clear uptrend? Now that is asking for trouble. There is no such thing as a clear uptrend. You see a clear uptrend after the fact... To say we are in consolidation is I would say wrong. We are in the "I have no freaken clue" phase. It could go up really fast, or could go down really fast. Or it could do nothing at all. There is no real clue. Personally if I was a gambling man I would bet on the extremes. You might get the death of a thousand cuts, but there will be a clear trend within the next six months. I would not bet on pullbacks and then to make call purchases. The problem being that the pullback might be a pulldown. For example, stocks have pulled back about 20% from their highs. This is not much considering how far the market has moved. And what is not yet factored into the American market is the strength of the USD. I am betting that CEO's will become pessimistic in the next round of earnings.
SANITY CHECK ? The title of this month's issue of MONEY magazine is "The 20 Best Money Websites... and the one's you should avoid." I quote, "Don't take investing advice from Yahoo Finance message boards." ROFL