RISK REWARD

&
STRIKE RATE
Introduction

In trading, we face decision making situation almost all times.

Suppose one initiated a trade, now he is in an open position.
He may be in some profit or loss(notional). He needs to make
decision whether to hold or exit.
The decision is to be made between two trade off in each scenario
In a winning trade, when one sees a
profit, he has to decide if to take it
or hold in anticipation for the profit
to grow. If he choses to hold, he
takes the risk of market to move
against him and losing all the
notional , exiting at cost or if not
then, perhaps with loss.

Similarly in a losing trade, one may

see some loss, then he has to take
decision
Whether to cut his losses at current
levels(500) or hold in “hope” of
recovering losses and exit cost to
cost, or perhaps in profit taking risk
simultaneously for extension of
loss(1000)
 Illustration
Winning the Trade

And see if it
can go to
Rs1000

Book @ Rs
Or hold
500

Taking Risk of
exiting at cost

And see if recovery

Enter a happens to cost
trade and
have an
open
position
Cut loss @
Or hold
Rs 500

Taking risk
of losing
even more ,
Rs 1000
Losing the trade
Poll Questions

This dilemma is explored in two scenarios as given below

The Problem is articulated as below

SCENARIO 1
There are two doors, you must open one of them and face
your fate

Door 1 - if chosen, you either owe Rs1000 or nothing

Door 2 - You owe Rs 500

SCENARIO 2
There are two doors, you must open one of them and face
your fate

Door 1 - if chosen, you either receive Rs1000 or nothing

Door 2 - You receive Rs 500

You either You You either You

give 500 owe(give) get 500 receive
Or Zero Rs 500 Or Zero Rs 500
(Nothing) (Nothing)
Poll Results and observations

Total Votes 2839 Scenario 1

Option Poll Result
I choose Door 1 40%
I choose Door 2 60%

Total Votes 3137 Scenario 2

Option Poll Result
I choose Door 1 26%
I choose Door 2 74%

As per polls, we can see that about 40% people chose Door 1 when
the question was about losing 500 or taking a chance of not losing
at all. This is more of an uncertain choice against, a fixed and
known loss of 500.

Whereas, When it came to making a choice between assured

return of 500(in scenario 2).74% people picked Door 2.

This shows us that when return opportunity is presented, people

tend to be going for assured returns and not willing to take
chance as they then see it as they are losing assured 500 if they
pick door 1 taking chance of getting zero even if it offered an
opportunity to make 1000.

But when it came to losing, as in 1st scenario, more people(40%)

are willing to take chance, anticipating there is a possibility to not
lose anything at all.
Combinations – Poll Results

Total Votes 2410

Option Poll Result
COMBO 1 Door 1 chosen in both scenarios 17%
COMBO 2 S1D1 & S2D2 23%
COMBO 3 S1D2 & S2D1 11%
COMBO 4 Door 2 chosen in both scenarios 49%
S1D1 & S2D2 = Scenario 1, Door 1 & Scenario 2, Door2
S1D1 & S2D2 = Scenatio1, Door 2 & Scenario 2, Door 1

We define each row as Combinations or COMBO numbered. The

combinations can be seen as cumulative result of consecutive
trades.

In further section, we intuitively explore the behavioural aspect

behind such choices. Develop an intuitive idea over which combo
would give better odds to a trader relative to others. And speaking
of odds, we also try to get a mathematical figure to see how it will
fare when the numbers are crunched.

We see that Combo 1 give us an understanding of Strike rate and

other three give us idea about Risk to Reward Ratio.
Combination 1

We take Net payoff outcome of each case scenario.

There are four possibilities, and each as 25% probability of

occurrence. That means, out of four possibilities, only 1 have
positive cash inflow. Or we can say, out of 100 trades, 25 times you
can expect to make positive cash flow.

This 25% will represent Strike Rate. This is a low strike rate, such
low strike rates would require very high Risk to Reward for net
positive cash flow in consecutive trades.

Cases Net Payoff Probability

Got zero in both cases 0 25%
Giving 500, Getting zero -500 25%
Giving zero, Getting 500 500 25%
Giving 1000 in both cases 0 25%
Combinations 2,3,4

Combo 2 Net Payoff Probability

Getting 500, Giving 0 +250 50%
Getting 500, Giving 1000 -250 50%

Combo 3 Net Payoff Probability

Getting 0, Giving 500 -250 50%
Getting 1000, Giving 500 +250 50%

Combo 4 Net Payoff Probability

Giving 500, Getting 500,
0 50%
This 50% means, that
Rs500 will be received
50% of the trades and
Rs500 will be given 50%
of times and hence we
have net zero

At prima facie , it all looks same, Net outcome seems zero.

Well, But all three are different. So, what is the difference?

In Combination 1, we have seen a low strike rate of 25%, here

in all three combinations, Strike rate is 50%

But difference is in Risk Reward!

COMBO 2 is taking risk of losing 2x of the assured return.

For example, you entered a trade, say, bought an option on expiry

day for Rs 50, after 15 minutes, you see the premium have come
down to 25. You put a limit order sell at 75. (This is Combo 1)

The money put at risk, 1000 ( Though 50% chance) Money

looking to receive 500 (Fixed and assured)

This means, one is risking 1000 against assured return of 500. Or

he is betting with risk reward of 1:0.50 or 2:1

So a strike rate of less than 70% would mean a negative cash flow.
Thus, only in case of high conviction of more than 70% this
approach may result in positive cash flow.

COMBO 3 a case of 1:2 Risk Reward, i.e., 1 rupee

risk taken against chance of earning Rs 2

For example, Buying an option for 50, putting a

stop loss of 25 and target of 100 Here, one is taking
limited risk of Rs25 on a losing trade but is taking
chance to get Rs50(2x) in a winning trade.

COMBO 4 is betting on
a risk reward of 1:1 with
strike rate of 50%, we
will see that the net
outcome in this
approach will be Zero.

In next section we see

giving us Expected
values with different
Risk to Reward and
strike rates
 Risk Reward – Strike Rate Matrix

Strike Rate
Risk Reward 10% 20% 30% 40% 50% 60% 70% 80% 90%
1 0.25 -88% -75% -63% -50% -38% -25% -13% 0% 13%
1 0.50 -85% -70% -55% -40% -25% -10% 5% 20% 35%
1 0.75 -83% -65% -48% -30% -13% 5% 23% 40% 58%
1 1.00 -80% -60% -40% -20% 0% 20% 40% 60% 80%
1 2.00 -70% -40% -10% 20% 50% 80% 110% 140% 170%
1 3.00 -60% -20% 20% 60% 100% 140% 180% 220% 260%
1 4.00 -50% 0% 50% 100% 150% 200% 250% 300% 350%
1 5.00 -40% 20% 80% 140% 200% 260% 320% 380% 440%
1 6.00 -30% 40% 110% 180% 250% 320% 390% 460% 530%

This matrix show us Expected Returns with Risk Reward (rows)

and Strike Rates(Columns)

With 1:1 Risk Reward and 50% Strike Rate, Net outcome is Zero
(Shown in Red box)

The Yellow boxes are the zones where one makes any positive cash
flow, Thus a risk reward and strike rate that maps to yellow zone
is desirable for a trader who is looking to make positive net cash
flow in is trading setup consistently

If trader lands in white zone, he is making loss.

Of course, it doesn’t account for transaction costs and taxes,

which will reduce the returns in all boxes

The objective for a trader would be to be in yellow zone, and

thus betting on a risk reward that suits him and keep
appropriate strike rate.
Risk Reward – Strike Rate Matrix & Combos
COMBO 2
SR SR SR
Risk Reward 25% Risk Reward 50% Risk Reward 50%
1 0.00 -75% 1 0.50 -25% 1 2.00 50%
1 0.50 -63%
COMBO 3
1 1.00 -50% SR
1 2.00 -25% Risk Reward 50%
1 1.00 0%
COMBO 1
COMBO 4

Out of the 4 Combinations, only Combination 3 falls in Yellow

Zone. In this case, intuitively 1:2 risk reward is selected and
therefore any strike rate above 40% will result in positive cash
inflow

The idea intuitively is to have adequate strike rate and working

with a favourable Risk Reward.

Many people may have been working on a system of working with

limited loss, and taking shorter but consistent profits. Think of
sayings like, “ I won’t lose more than 1 % of my capital”, “ Do not
be greedy, take the profits that are coming near your levels”, “
Even if shorter, but consistent profit making is better than taking
risk for more profits” – All this may sound like 4th Combination.

True, if 1:1 risk reward has strike rate of 60% or more, net positive
will come. The word Consistency means higher strike rate. So
combination 4 is systematic, with a 1:2 or higher risk reward and a
60-80% strike rate, it can do wonders. Combination 3, is more
discretionary and intuitive. Professional traders may have been
noticed for targeting 1:3 or 1:4 risk reward, with 80-90% strike
rate.
Further Exploration – Option Sell Case
Strike Rate
Risk Reward 10% 20% 30% 40% 50% 60% 70% 80% 90%
1 0.25 -88% -75% -63% -50% -38% -25% -13% 0% 13%
1 0.50 -85% -70% -55% -40% -25% -10% 5% 20% 35%
1 0.75 -83% -65% -48% -30% -13% 5% 23% 40% 58%
1 1.00 -80% -60% -40% -20% 0% 20% 40% 60% 80%
1 2.00 -70% -40% -10% 20% 50% 80% 110% 140% 170%
1 3.00 -60% -20% 20% 60% 100% 140% 180% 220% 260%
I am1 a Option
4.00 -50% 0%I literally
Seller, 50% 100% 150%
assume 200% 250% 300% 350%
1 5.00 risk
Unlimited -40%for20% 80%reward
a finite 140% 200% 260% 320% 380% 440%
1 6.00 -30% 40% 110% 180% 250% 320% 390% 460% 530%
every time I trade, But I still make
money. So?????
Minimum
Yes it is true that Option Seller trades
Risk Reward Strike Rate
with Unlimited Risk and his reward is
limited. Even if one uses Hedging or Stop Rqd
Loss, The reward is a fraction of what is 1 0.05 95%
put in the trade. 1 0.10 91%
1 0.15 87%
However, Most option sellers uses a 1 0.25 80%
strategy of Selling Out Of Money and the 1 0.50 67%
Strike(Option Strike) they pick is in their 1 0.75 57%
individual analysis and assessment, that 1 1.00 50%
strike that has a higher probability of 1 2.00 33%
expiring Worthless. So, one can view 1 3.00 25%
them as a person in the 90% Strike 1 4.00 20%
Rate(Not to be confused with option 1 5.00 17%
Strike price). So they be in yellow zone 1 6.00 14%
even with less than 1:1 Risk Reward.

In the right is a table to show what minimum Strike Rate( or

conviction probability) is required with different Risk Reward
combination -
Poll Credits
The poll was conduced on Telegram Channel Learning Markets
with Manish (https://t.me/LearningMarketsWithManish)

Below are actual Poll results screenshots as of writing of this -

Poll Credits
The poll was conduced on Telegram Channel Learning Markets
with Manish (https://t.me/LearningMarketsWithManish)

Below are actual Poll results screenshots as of writing of this -

Disclaimer
The views expressed are Personal of author(NOT SEBI Registered), The
Telegram channel has not affiliation with his Opinions. No one including
the author has any liability of one’s actions or consequences there of in
investments or otherwise whatsoever. Investment are subject to market
risk, Please consult your Financial Advisor before making any decision.

The material is purely of Education and understanding purpose. Not for

Profit or Commercial Use.

By - https://t.me/caesar_julius