Most traders prefer a 2-to-1 reward-to-risk ratio for trades in the spot market. The same rule can be used for futures, as they move nearly one-to-one with their underlying. The issue arises when you trade options. Options do not move one-to-one with the underlying because of time decay. This week, we discuss the issues in determining the reward-to-risk ratio for option traders.
Delta changes
Suppose you buy the next-week 24900 Nifty call when the index is at 24837. This option is at-the-money (ATM) with a delta close to 0.50. Suppose your view is that Nifty Index will retest 25236. The upside potential in the index is 399 points (25236 less 24837); 24900 call will then become in-the-money (ITM). Importantly, the intrinsic value of an option moves one-to-one with the underlying. So, if the Nifty Index were to retest 25236, the 24900 call will carry 336 points of intrinsic value (25236 less 24900). Now, if this price target is achieved at expiry, 24900 call will carry only intrinsic value, as time value will be zero at expiry. This makes it easily to determine the profit potential at expiry. At that time, the reward-to-risk ratio will be nearly 2-to-1 (intrinsic value to cost). It also means if the price target is achieved before expiry, the reward-to-risk ratio will be better. This is because the option will also carry some time value and, hence, will have a higher price than 336.
There are two issues with the above discussion. One, you cannot carry a European option with large intrinsic value. This is because the deep ITM option may not be easily tradable as traders do not prefer to buy options with higher absolute price. So, you may have to sell the option earlier and take profits, when the intrinsic value is significantly lower. That means lower reward-to-risk ratio. And two, what if you buy an out-of-the-money (OTM) call and sell the option when it is closer to ATM? In both scenarios, the reward-to-risk ratio cannot be determined unless you apply Black-Scholes-Merton model to determine the option value (and time decay). This is because time value of an option is a residual factor; you must know the option price and the intrinsic value to calculate the time value any time during the life of the option. Suppose you buy the 25300 next-week OTM call. If the Nifty Index were to trade at 25236 three days before expiry, the call could be worth 69 points, a gain of 16 points, assuming no change in implied volatility. So, your option positions could have lower than 2-to-1 reward-to-risk ratio.
Optional Reading
It may not be optimal to hold deep ITM equity calls till expiry. You will have to take delivery of the underlying, which requires large trading capital. The upshot? You may have to lower your reward-to-risk ratio to close your positions sooner. The trade-off: lower time decay and better liquidity vs lower delta gains.
(The author offers training programmes for individuals to manage their personal investments)
Published on August 2, 2025
