What is a low-risk options trade? It’s a simple question with a not so simple answer. Today we’re going to talk about why it’s complicated and explore the relationship between risk, reward, and probability.

Stock Traders are Cavemen

If we rephrased the question to ask what a low-risk stock trade was, then it would be easy to answer. That’s because risk and reward are all about the setup or chart pattern that you’re trading. We feature low-risk, high reward ideas every single week in our Scouting Reports.

Risk is not absolute. It’s relative. Relative to reward, that is. If you tell me you’re entering a stock trade with $3 of potential loss, then it’s not as revealing as you might think. I don’t know if it’s a good play unless you tell me about the potential reward. It’s risk relative to reward that matters.

Risk $3 to make $6 = Me Like!

Risk $3 to make $1 = No Like!

Stock trading is just that simple. Think of stock traders as cavemen. Theirs is a base language with very few variations of expression. Grunts and shrugs are the standard communications and that’s about it. But that’s what makes equity trading so easy to grasp. It’s all about risk versus reward and up versus down.

But options trading? Now that offers a more sophisticated means of communicating. Like the advanced language of the Heptapods in one of my favorite sci-fi flicks, Arrival.

You can be incredibly articulate in the way you express yourself with options. You can bet on direction, but also speed and magnitude. Because of all of the possibilities and combinations, strategies exist that offer every possible variation of risk versus reward. You can risk a lot to make a little or risk a little to make a lot.

I know what you’re thinking.

“Why don’t I just risk a little to make a lot? It sounds like a good idea, no? Why isn’t that the definition of a low-risk options trade? One that risks a small amount of money?”

Those are good thoughts so I’m going to reward you for our curiosity.

With stock trading, you can look at risk versus reward in a vacuum. With options trading, you can’t. There’s another dimension that enters the equation – probability. As in, probability of profit (POP for short) or the likelihood you will capture the reward.

The reason you don’t have to take POP into account with stock trading is it never changes. The baseline odds for a stock trade are always 50-50. But for options, the POP changes depending on how you structure the trade.

How Do YOU Define Low-Risk?

Is a low-risk options trade one that only loses a small amount of money if you’re wrong, or is it one that only has a slight chance of losing money? These are not the same thing.

Low dollar risk, but low POP. (i.e., 70% chance I lose $100, 30% chance I make $300)

High dollar risk, but high POP. (i.e., 70% chance I make $100, 30% chance I lose $300).

I don’t know the answer to this tantalizing question. What I do know is it underscores that you have to take into account probability when making decisions on options trades. The best way to illustrate the trade-off is with a bull call spread.

Suppose we have a $205 stock that boasts a bull retracement pattern. The chart offers a so-called low-risk, high-reward setup. If you were buying stock then we could end the discussion here, content that you put your self in a “low-risk” trade. But I’m making you build an options trade instead. A bull call spread, to be exact. Here are your choices:

So, which one are you going to take? Risk is not just a function of the dollars at risk in the trade. Nor is it solely a function of the probability of profit. It’s a byproduct of both.

This is why it’s not easy to answer the question, “what is a low-risk options trade?”

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