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David A. Bean's Health, Wealth, and Wisdom Web PagesFINANCIAL REALITY!
Risk/Reward Ratio Evaluation for
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Most advisory services, when they show their "past results" tables,
neglect the effects of commissions.
And, when they indicate targets and stop losses, they often base them on
risk/reward ratios that neglect the effects of commissions.
They COULD include the effects of typical commissions, but that
would mean their numbers would not be nearly as impressive.
What is their excuse?
The excuse is that commissions vary from broker to broker, so indicating
commissions would be a problem.
I say -- bullcrap -- they COULD include the effects of typical
commissions and thus present more realistic numbers.
I will give a couple of examples -- a stock play and a related options
play -- with and without commissions.
The commissions will be as Scottrade charges (2006 May).
Their commissions are representative -- not the lowest, not the highest.
BTW, anyone using the services of a "full-service" broker for trading is a fool. The effects of their much higher commissions just about guarantee LOSSES in trading. If you are with a full-service broker, you should not be trading. And good luck to you with their management services. You'll need it.By typical commissions, I mean the commissions of discount brokers offering on-line trading for self-directed traders. Self-directed traders can include traders who may get their trades from advisory services, but who place their trades themselves, without input from a broker's "customer rep". (Shown typically on trade confirmations as an "unsolicited order".)
LIBERTARIAN, OBJECTIVIST, CONSERVATIVE --
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Here is an example of a recommendation that a friend of mine received the other day. I have changed the name of the stock and the option. Options prices relative to the price of the stock at various levels have been estimated.
The advisory recommended just a stock play. I have added a related option play for illustration, as some services also recommend both stock and options plays.
The stock is XYZ, and closed Thursday 2006-05-25 at $4.47.
The recommendation came out Thursday night for a possible Friday trade.
I didn't receive the information from my friend until after the market
close on Friday.
In real life, the trade was not taken because the entry price trigger
was missed by $0.04, but for the purposes of analysis, it will be assumed
that there was an entry into the trade.
The stock, in real life, closed on Friday at $4.50.
That established the option price base used in the example.
The option is XYZRA (2006 Jun 5.00p) --
an In the Money (ITM) Put option.
It was at $0.50 bid - $0.55 ask at the close on Friday.
The service recommended to enter a short under $4.42.
I will assume a short sale entry at a stock price of $4.41.
I will assume the Put will then be at $0.60 bid - $0.65 ask.
The service is looking for a $0.30 or more move (down) after entry,
for a profit.
That would make the target price $4.11 or less.
I will assume a $4.11 target.
I will assume the Put will then be at $0.90 bid - $0.95 ask.
The service recommends a buy stop (stop loss) over $4.56.
I will assume $4.57, and if hit, that will be the price bought back at.
I will assume the Put will then be at $0.45 bid - $0.50 ask.
The stop loss appears to be set just above the high of the last three days. I have no idea as to how the profit target was set -- OTHER THAN IT IS AT A PRICE THAT JUST HAPPENS TO RESULT IN A POTENTIAL REWARD OF ABOUT TWICE THE RISK.
ENTRY PROFIT LOSS
TARGET EXIT
STOCK $4.41 $4.11 $4.57
OPTION 0.60 - 0.65 0.90 - 0.95 0.45 - 0.50
Stock profit projected (REWARD): $4.41 - $4.11 = $0.30
Stock loss projected (RISK): $4.57 - $4.41 = $0.16
Reward/Risk: $0.30 / $0.16 = 1.875
Most advisories seem to think (?) that those stock traders following their recommendations are trading tens of thousands of dollars per trade. I don't think so. I think those trading that size, are figuring out their own trades. I think those using advisories are making trades of just a few thousand dollars for stocks and a few hundred dollars for options. (For options, that would be 5 to 10 contracts, depending on the price of the options.)
In this example, I am assuming 500 shares of XYZ and/or 5 Puts.
WITHOUT COMMISSIONS WITH COMMISSIONS
Short 500 shares @ $4.41
Net proceeds $2205.00 $2205.00 - $7.00 = $2198.00
Profit buy back @ $4.11
Net cost $2055.00 $2055.00 + $7.00 = $2062.00
-------- --------
Profit $ 150.00 $ 136.00
Loss buy back @ $4.57
Net cost $2285.00 $2285.00 + $7.00 = $2292.00
-------- --------
Loss $ 80.00 $ 94.00
P/L (Reward/Risk) Ratio
$150.00 / $80.00 = 1.88 $136.00 / $94.00 = 1.45
MARGINAL NOT GOOD
A common rule of thumb, to ensure profitability over a series of trades, is to only make trades where the reward risk ratio meets a minimum requirement. This is commonly set at 3+ desired, and 2 as an absolute minimum.
You can see that the trade above is marginal at best without commissions, (~1.9 ratio) and is a NO GO (~1.4) if you realistically include commissions.
What would it take to get a realistic 2:1 ratio out of the above trade,
assuming the same stop loss?
I am using the stop loss as the constant, and figuring the profit
target required, as the
stop loss seems less likely to have been picked out of someone's
ass than the profit target.
The stop loss seems based on a swing high resistance, but who knows
how the profit target was picked.
The risk is $94.00, so the profit target needed is at least double that, or $188.00
That means the stock has to go down to $4.01, not just to $4.11
$2198.00 net proceeds from the short sale - $188.00 = $2010.00
$2010.00 - $7.00 = $2003.00
$2003.00 / 500 = $4.006
(Verification of the above calculation)
Buy back at $4.006 --> $2003.00 + $7.00 --> $2010.00 net cost
Profit --> $2198.00 previous net proceeds - $2010.00 --> $188.00
This means that to get the desired minimum 2:1 reward/risk ratio,
the actual price differential move ratio required is:
($4.41 - $4.006) / ($4.57 - $4.41) = $0.404 / $0.16 = 2.525
That is somewhat higher than 2:1, isn't it?
risk reward ratio risk / reward risk/reward risk reward relationship risk & reward risk tolerance reward/risk ratio reward / risk
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Now that you know how important taking account of commissions in stock
plays is, take a look at them with options plays.
Be afraid, very, very afraid.
The bid - ask spread in options is bad enough; $0.05 is the best that
you, the average trader with most brokers, can expect;
it is often much more.
But that is not the half of it --
commissions are a substantial percentage of a typical options trade
cost, unless you are trading tens of contracts at a time.
WITHOUT COMMISSIONS WITH COMMISSIONS
At the short entry price of $4.41
Puts at $0.60 bid - $0.65 ask
Buy 5 Puts (Jun 5.00p) @ $0.65
Net cost $ 325.00 $ 325.00 + $ 13.25 = $ 338.25
At the stock profit point of $4.11
Puts at $0.90 bid - $0.95 ask
Profit sell to close @ $0.90
Net proceeds $ 450.00 $ 450.00 - $ 13.25 = $ 436.75
-------- --------
Profit $ 125.00 $ 98.50
At the stock stop loss point of $4.57
Puts at $0.45 bid - $0.50 ask
Loss sell to close @ $0.45
Net proceeds $ 225.00 $ 225.00 - $ 13.25 = $ 211.75
-------- --------
Loss $ 100.00 $ 126.50
P/L (Reward/Risk) Ratio
$125.00 / $100.00 = 1.25 $98.50 / $126.50 = 0.78
BAD WORSE
The risk is $126.50, so the profit target needed is at least double that, or $253.00
That means the stock has to go down to about $3.80, not just to $4.11
$338.25 cost + $253.00 profit needed = $591.25
$591.25 + $13.25 = $604.50 gross needed
$604.50 / 500 = $1.209 Put sell price required
(But can't get an odd number, so has to be $1.20)
That means the Puts have to be In-the-Money (ITM) by $1.20,
meaning the stock has to go down to about $3.80
(Verification of the above calculation)
Stock @ $3.80 --> Puts at about $1.20 bid - $1.25 ask
Sell Puts back at $1.20 --> $600.00
Net Proceeds --> $600.00 - $13.25 --> $586.75
Profit --> $586.75 - $338.25 --> $248.50
(If could get the unrounded price of $1.209 for the Puts, the profit would be $253.00)
This means that to get the desired minimum 2:1 reward/risk ratio on the Puts,
the actual stock price differential move ratio required is:
($4.41 - $3.80) / ($4.57 - $4.41) = $0.61 / $0.16 = 3.81
That is somewhat higher than 2:1, isn't it?
WITHOUT COMMISSIONS WITH COMMISSIONS
At the short entry price of $4.41
Puts at $0.60 bid - $0.65 ask
Buy 10 Puts (Jun 5.00p) @ $0.65
Net cost $ 650.00 $ 650.00 + $ 19.50 = $ 669.50
At the stock profit point of $4.11
Puts at $0.90 bid - $0.95 ask
Profit sell to close @ $0.90
Net proceeds $ 900.00 $ 900.00 - $ 19.50 = $ 880.50
-------- --------
Profit $ 250.00 $ 211.00
At the stock stop loss point of $4.57
Puts at $0.45 bid - $0.50 ask
Loss sell to close @ $0.45
Net proceeds $ 450.00 $ 450.00 - $ 19.50 = $ 430.50
-------- --------
Loss $ 200.00 $ 239.00
P/L (Reward/Risk) Ratio
$250.00 / $200.00 = 1.25 $211.00 / $239.00 = 0.88
BAD STILL WORSE
The risk is $239.00, so the profit target needed is at least double that, or $478.00
That means the stock has to go down to about $3.85 or $3.80, not just to $4.11
$669.50 cost + $478.00 profit needed = $1147.50
$1147.50 + $19,50 = $1167.00 gross needed
$1167.00 / 1000 = $1.167 Put sell price required
(But can't get an odd number, so has to be $1.15 or $1.20)
That means the Put has to be In-the-Money (ITM) by $1.15 or $1.20,
meaning the stock has to go down to about $3.85 or $3.80
(Verification of the above calculation)
Stock @ $3.80 --> Puts at about $1.20 bid - $1.25 ask
Sell Puts back at $1.20 --> $1200.00
Net Proceeds --> $1200.00 - $19.50 --> $1180.50
Profit --> $1180.50 - $669.50 --> $511.00
Stock @ $3.85 --> Puts at about $1.15 bid - $1.20 ask
Sell Puts back at $1.15 --> $1150.00
Net Proceeds --> $1150.00 - $19.50 --> $1130.50
Profit --> $1130.50 - $669.50 --> $461.00
(If could get the unrounded price of $1.167 for the Puts, the profit would be $478.00)
This means that to get the desired minimum 2:1 reward/risk ratio on the Puts,
the actual stock price differential move ratio required is:
($4.41 - $3.85) / ($4.57 - $4.41) = $0.56 / $0.16 = 3.50 to
($4.41 - $3.80) / ($4.57 - $4.41) = $0.61 / $0.16 = 3.81
That is still somewhat higher than 2:1, isn't it?
Take the numbers provided by advisory services with a BIG grain of salt. If they don't apply the effects of commissions to their stated numbers, whether P/L results or risk/reward ratios, you will have to calculate that yourself, if possible. At least make an estimate. Otherwise you may be unhappily surprised.
And, if you have some spare time and like tilting at windmills, you could write or e-mail them and point out that they COULD at least include the effects of representative commissions in the numbers they provide.
There are thousands of books concerning trading the stock, options, and futures/commodities markets. They cover all areas of interest, ranging from technical analysis to risk management and money management.
To see some of the most highly recommended of these,
visit the following pages:
http://www.bean-d.com/finance/top5-technical-analysis-books.php
http://www.bean-d.com/finance/technical-analysis-books.php
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