Know Your Risk and Reward
You’ve doubtless heard of the saying, “There’s no such thing as a free lunch.” It’s a cliché, but it’s a cliché for a reason. It’s true, especially when it comes to Wall Street.
Understanding the relationship between risk and reward is a crucial ingredient to successful trading or investing. Generally, you won’t get something for nothing.
For a higher return, you typically have to take on higher risk. If you want something with low risk, you typically have to settle for a lower return. This relationship is clearest when the return is fixed, such as with a fixed-rate bond. If you want higher interest, you have to buy a longer-term bond and/or buy a bond with a lower debt rating (higher default risk).
Expectation vs. Reality
When you are dealing with investments whose return isn’t fixed—such as a stock—then you are dealing with expected risk and return.
To buy a growth stock (the company is expected to increase sales and cash flow quickly) you likely have to pay for a high valuation (e.g., price-to-earnings, price-to-sales, etc.).
Value stocks are cheaper in that their valuation metrics are lower, but they aren’t expected to grow very much. This means for a growth stock you may have to pay 50x earnings, while for a value stock you pay only 8x.
Market expectations are not always correct, but in the long run, the risk/reward relationship stands. You won’t often find a growth stock that’s trading cheaply (low valuation, NOT necessarily low price), unless there were some problems under the hood.
In the short term, though, the market can get out of balance and create opportunities. For example, in the recent coronavirus-induced crash, many market participants who used too much leverage were forced to sell. Others sold out of fear. This worsened the market slide, but it also created buying opportunities. For a short while you could find some quality stocks selling at a discount, but that window didn’t stay open for very long.
Mispricing Creates Opportunity
To achieve a higher return than the market indexes, it helps to find stocks that are mispriced. This could mean buying a stock that’s undervalued or shorting a stock that’s overvalued. The key is to tilt, even if only slightly each time, the risk/reward balance consistently in your favor. You want to optimize your risk/reward balance by finding investments that offer a relatively high (expected) return for relatively low (expected) risk.
And if you trade options, because options offer so much versatility and flexibility, you have even more ways to try to capture an edge.
As with stocks, when picking what option to buy or sell, you have to make a choice along the risk and reward spectrum. From the buyer’s viewpoint, you pay a low premium when you buy an out-of-the-money (OTM) option, but there’s a high chance that the option simply expires worthless. If you held your option to expiration, you lose all of the premium you paid.
But if the unlikely happens, you could achieve a big return. For example, if you pay $0.10 for a very OTM call option, and the underlying stock makes a big jump, and the option ends up being worth $5, you have made a fifty-fold gain. Overnight gains of 1,000% or higher in an option aren’t that rare. Even if your option expired worthless 99 out of 100 times, if you make a massive gain on the 100th trade, that one gain could be enough to cover the losses on the other 99 trades!
From the seller’s perspective, there’s a high chance that a very OTM option will expire worthless (a good thing for the seller) but he/she won’t get much for the premium. And if the stock moves against him/her, then he could lose a lot from the trade. In other words, the option seller is getting a low reward for writing the option, but even though the probability of loss also is low, if the unfortunate did happen, the loss amount would be high.
Thus, depending on the option seller’s preference, it may make more sense to sell an option that’s closer to the money. The risk that the option will end up in the money would be higher but in return the option seller collects a higher premium for taking on risk.
Whether you are buying or selling, however, the important factor to understand is what kind of risks you are taking on and what type of return you can expect. If you aren’t comfortable with the risk/reward profile of a trade or investment, it’s better to look for something else.
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Dr. Leeb is chief investment strategist of The Complete Investor, a trading service on which Scott Chan is the lead analyst.
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