Previously in this column, we discussed reward-to-risk ratio for options trading. We showed why option positions may have reward-to-risk ratio less than 2-to-1, a ratio that traders typically want from their futures or the spot positions. This week, we discuss why risk- the denominator of the ratio – is difficult to determine for options.
What risk?
Risk is defined as the possibility of loss in the future. When you buy out-of-the-money (OTM) options, you pay only for the time value of the option. This component of the option price must become zero at expiry. Therefore, it is a loss, not a risk. So, determining risk at expiry means determining the loss relating to the cost of the option. Therefore, the reward-to-risk ratio considers the intrinsic value of the option to the cost of the option. Note that the price of the option at expiry is equal to its intrinsic value. This value can be determined today, assuming the underlying reaches your price target at expiry.
What if the underlying reaches your price target any time during the life of the option? You must first determine the value of an option using a valuation model, assuming that the price target will be achieved at that time. Using a valuation model is necessary because the time value component of an option cannot be determined in isolation. This is because the time value component is a residual component, determined by subtracting intrinsic value from the option price. Once you determine the option value, you can find out the potential gains (option value less cost), the numerator of the ratio.
Determining risk, the denominator of the ratio, can pose a problem. Typically, risk in futures and spot trades can be easily determined. This is the difference between the entry price and the stop-loss. This process cannot work for options. Why? You cannot trade options using the option price charts. Instead, you must use the underlying price chart to trade equity options and futures price chart to trade index options. So, your stop-loss level must be fixed on a base price chart such as the stock or index futures, but the action must be taken on an options position. It is likely that the option will be OTM when the underlying hits the stop-loss. But that is the issue. OTM options will have some value before expiry, and zero value at expiry. So, if you were to consider the maximum risk on the position, then you must take the cost of the option.
Optional reading
The simplest way to determine reward-to-risk ratio is to look at the ratio, assuming the price target is achieved at expiry. If your satisfied with the reward-to-risk ratio, then you should initiate the position, for the ratio will be better if the price target is achieved any time before expiry. This is because you can capture some time value when you sell the option before expiry.
(The author offers training programmes for individuals to manage their personal investments)
Published on August 9, 2025
