Trading Plans: Profit vs. Loss

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I’ve stressed the benefits of writing a trade plan for each trade. This seems to be one of those things that is easier to ignore and many question the worth of such plans.

Before entering into any trade – especially a trade with limited profits, it’s important to know just how much can be earned so that it can be compared with the maximum possible loss. Without having an idea of the profit potential, there is no sensible method for deciding whether to make the trade. The thought process may resemble this:

Considering how much I can lose if things don’t work out well, and taking into consideration the probability of losing that much, is the potential profit (and the chances of earning that profit) worth taking the risk?

Let’s take a look at an example – one that I’ve used previously.

The trade: Buy (I know, most people prefer to use the term ‘sell’) a 20-point iron condor and collect a cash credit of $4.00. The underlying asset is a broad based index, such as SPX, NDX, or RUT.

Maximum theoretical gain: $4.00

Maximum theoretical loss: $16.00

We could look at the delta of the short options, or use a probability calculator to give us an idea of how likely it is that the position would finish safely out of the money. We could determine the probability that one of the options would become an ATM option (‘probability of touching’) during its lifetime. In other words, we have some idea of the statistical chances of success/failure.

To determine if you want to own this trade, you should not look at those $4 and $16 numbers, unless you know that you are going to hold this trade all the way through expiration. That would be a terrible idea and is a slap in the face to those of us who believe that risk management is essential to making money when trading.

For traders who do hold, these $4 and $16 numbers are real and the trader achieves one of these result in the vast majority of situations. A small percentage of the time the gain or loss is different, but that requires that the settlement price be within the borders of either the call or put spread. [When the short option is out of the money, then the profit is $4. When the long option is in the money, then the loss is $16. If neither of those situation obtains, then the final settlement price is between the strikes and the 20-point spread is worth anywhere between $0.01 and $19.99.]

Exercise risk management skills

For those of us who know we will neither allow the options to expire worthless nor allow the loss to reach the maximum, we must estimate a maximum profit or loss. Sure we all think of the chances of earning the whole $4, but the risk involved makes it a poor decision – for my comfort zone. I’ve often discouraged readers from seeking every last nickel from a trade.

The point of this post is to alert plan writers to the fact that the theoretical limits are not realistic and you are far better served to enter profit/loss targets that are realistic according to your own guidelines. I would probably use numbers such as $3.50 as the maximum gain and perhaps as high as $8 for the maximum loss. Note: that is a personal trading style, not a recommendation.

In reality, I never seek that maximum gain, while other go after seek every penny. There is no arguing with the fact that leaving money on the table is not the path of the expert trader. However, deciding how much profit is enough, and when the reward no longer justifies taking any risk, is something that comes with experience.

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2 Responses to Trading Plans: Profit vs. Loss

  1. Paul D 03/08/2011 at 8:52 AM #

    Good point here. I learned alot of options theory in college and while it does make for tidy math, you do need to adjust when for realistic events when trading.

    • Mark D Wolfinger 03/08/2011 at 9:02 AM #

      Paul,
      I spent a lot of years in school (PhD, Chemistry) many years ago and I understand the value of academic research and theory.
      I would not go against the stuff you learned – it has it’s importance. However, the real world of trading is just different – and that’s something the academic world doesn’t grasp.

      Some ‘studies’ require trades – to stick with the game plan of the study – that no sane trader would make. That’s also eality.

      Thanks for sharing