Understanding Risk and Reward Strategies for Futures and Options
One of the most important things for a trader to work towards is a basic knowledge for assessing the risk and reward associated with each trading strategy. It wouldn’t make much sense to undertake a trading strategy with unlimited risk for a fractional or minimal reward possibility. After all, money management in trading will be valuable in preserving risk capital.
There are many futures and options trading strategies which carry limited reward for substantial and unlimited risk. You will make more educated decisions in preserving your risk capital knowing which strategies will provide the best risk to reward ratio and give you solid money management while trading.
For futures trading, long and short futures positions are unlimited in risk. Short futures positions can profit all the way to zero, but the likelihood that a future commodity will be worth nothing is remote. Long commodity futures trading strategies carry the possibility of unlimited upside price movement potential. Again, the chance that a commodity price would go straight upwards unchecked is remote. When trading straight futures positions, commodity traders will often employ stop loss orders to hopefully minimize exposure but there is no guarantee. A futures trader should also consider using a limit order for a profit target at the same time as employing a stop loss order. These two orders may work in a sensible proportion to each other. For example, a stop loss which risks an overall 10 point loss is not wisely placed with a limit order seeking a 2 point gain. Remember wise money management while trading! The use of stop loss or contingent orders may not protect profits, and may not limit losses to the amount intended. Certain market conditions may make it difficult or impossible to execute such orders.
Commodity option trading is attractive to many futures traders because long option strategies have full premium loss as the maximum risk and this helps options traders establish money management in trading. However, less expensive options are priced lower for a reason. Option pricing is based on a few factors which relate to the probability that the option would be in the money prior to expiration. These factors are collectively known as the terms and while you may find some options which risk only a few hundred dollars, it is more likely that they will expire worthless in a purely mathematical assessment of the option.
Option trading strategies like spreads have increased in popularity because they will normally reduce the initial costs for long options and often enable the buyer to purchase closer to the money options for the same initial premium cost. Since closer to the money options may have a higher opportunity to be near or in the money prior to expiration, this may normally increase the possible risk to reward and provides another viable money management trading technique.
Trading in futures and options involves a substantial degree of a risk of loss and is not suitable for all investors. Past performance is not indicative of future results.
