Reward to risk analysis is only as good as your ability to define the reward and define the risk but then to also be conservative (honest) in your parameters.
For example, stock XYZ that continues to make all-time-high after all-time-high and the trade is an upside play using a call vertical spread. Since it is making new highs, technical analysis gives us very little guidance, as it will identify nothing in the way of resistance. So, we have to look at the implied volatility (IV) to target a range given the confidence interval we want to define.
Let’s say XYZ is trading at $90.00 and our IV analysis suggests a $94.00 strike at expiration. The 92.5/95 call spread is trading $0.75, so our reward to risk ratio would be 2.33:1 ((2.5-.75)/.75)=2.33.
That’s pretty good reward to risk and we would trade this signal, correct?
Not so fast! It is true that if we were to max out our spread our reward to risk ratio would be 2.33:1, but, we said our IV analysis suggests that we should only expect to get to 94.
If this is true, then our reward to risk ratio is quite different. We would calculate it like this: ((1.5-.75)/.75)= 1.
Reward to risk is only 1:1 when we are honest with ourselves with our actual potential profit.
