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In my first article about options myths and misconceptions, I presented several common myths about options trading. As a reminder, some of the misconceptions include:

  • The only profitable way to trade options is buying calls or puts.
  • You should aim for at least 100% gain in each option trade, otherwise it is not worth the risk.
  • You can have many failed trades but few big winners will cover those failed trades.
  • You need a lot of luck to be successful in options trading.

In this article, I would like to talk about risk/reward of non-directional trading.

I got the following email from one of my traders:

"Non-directional strategies offer very limited returns while still have sizable risks in my opinion. I am not sure the risk-return profile is attractive enough."

This is another common misconception. In fact, it is up to you to set your own risk/reward of the trade. I described here few different ways to structure a Google (NASDAQ:GOOG) earnings trade, based on your belief where the stock will be trading after earnings. Each one of the three trades has its own risk/reward and probability of success.

Let's examine three possible Apple (NASDAQ:AAPL) non-directional trades, using the April 2012 options. I will be using a strategy called an Iron Condor. The Iron Condor is a combination of a bull put spread and a bear call spread. The whole trade is done for a credit. The trades are based on February 29, 2012 prices when the stock was trading around $535.

Trade #1

  • Buy AAPL April 2012 455 puts
  • Sell AAPL April 2012 460 puts
  • Sell AAPL April 2012 615 calls
  • Buy AAPL April 2012 620 calls

Total credit: $0.95

Maximum gain: 23%

Downside protection: -14%%

Upside protection: +15%

Probability of success: ~80%

Trade #2

  • Buy AAPL April 2012 495 puts
  • Sell AAPL April 2012 500 puts
  • Sell AAPL April 2012 575 calls
  • Buy AAPL April 2012 580 calls

Total credit: $2.50

Maximum gain: 100%

Downside protection: -7%%

Upside protection: +7%

Probability of success: ~50%

Trade #3

  • Buy AAPL April 2012 520 puts
  • Sell AAPL April 2012 525 puts
  • Sell AAPL April 2012 545 calls
  • Buy AAPL April 2012 550 calls

Total credit: $4.00

Maximum gain: 400%

Downside protection: -3%%

Upside protection: +3%

Probability of success: ~20%

All gains and probabilities are based on holding until expiration. The maximum gain or loss for the Iron Condor trade is always realized only if held through expiration.

So if you are going to make one of those trades, you can choose the strikes based on your belief where the stock will be trading by April expiration. To realize the maximum gain, the stock has to trade between the short strikes, so all options expire worthless.

In trade #1, you are risking $4 to make $1. The trade is protected against 15% move in either direction. Based on the deltas of the short strikes, the trade has probability of ~80% to expire worthless.

In trade #2, you are risking $2.5 to make $2.5. The trade is protected against 7% move in either direction. Based on the deltas of the short strikes, the trade has probability of ~50% to expire worthless.

In trade #3, you are risking $1.00 to make $4.00. The trade is protected against 2% move in either direction. Based on the deltas of the short strikes, the trade has probability of ~20% to expire worthless.

As we can see, probability of success is directly related to the potential gain. You can have better risk/reward but lower probability of success. If you want higher probability of success, you need to settle for lower potential gain.

I shared few similar trades with Seeking Alpha readers. When Cisco (NASDAQ:CSCO) was trading around $19.30, I shared the following Iron Condor trade:

  • Buy CSCO March 2012 16 put
  • Sell CSCO March 2012 17 put
  • Sell CSCO March 2012 21 call
  • Buy CSCO March 2012 22 call

The trade was based on a belief that the stock will be trading between $17 and $21 in the next 7 weeks. It could be closed for 22% gain in three weeks.

About a week ago, I shared the following International Business Machine (NYSE:IBM) trade:

  • Buy IBM April 2012 175 put
  • Sell IBM April 2012 180 put
  • Sell IBM April 2012 205 call
  • Buy IBM April 2012 210 call

The trade was based on a belief that the stock will be trading between $180 and $205 in the next 8 weeks.

This is the beauty of those trades. You can structure them based on your risk tolerance and your belief where the stock will be trading during the life of the trade. You can truly become your own Risk Master.

Source: How To Become Your Own Options Risk Master