Reward to risk is not the be-all-end-all of risk management. I talk about this concept all the time in my classroom. Recently, Macy’s Department Store (M) was a topic of discussion regarding risk-reward is risk management. A student was looking for an opportunity to take a directional long in M, so we did some live analysis in the classroom.
There are no weekly options available for M, and our time horizon was longer than one day, so we were considering January expiration.
Using the implied volatility to give us a probability envelope for January, we were targeting the $67.5 area. The strikes were pretty limited, so we had to consider only using the 62.5, 65 and 67.5 strikes.
The two spreads we were considering were the 62.5/67.5 call spread for $1.50 and/or the 65/67.5 call spread for $0.50.
The 62.5/67.5 call spread had a reward to risk ratio of 2.33:1 (max reward is the distance between the strikes less what we pay divided by our max risk of what we pay in premium (2.5-1.5)/1.5 = 2.33). The 65/67.5 has reward to risk of 4:1.
“So, the 65/67.5 spread was far better right?” I asked. Yes, a 4.1:1 is better than 2.33:1. That is true, but those ratios were reflecting the spreads maxing themselves out.
“What if we never get there?” I asked. I went on to explain, “The 62.5/67.5 spread “kicks in” $2.50 before the 65/67.5 one does, so, you have to assign probabilities to each outcome and compare that. This certainly has a subjective slant to it but it is how you have to approach it.”
Which spread would have been better? Only hindsight can provide an answer to that question.
#####
To learn more about live trading, please click here.
