Risk-reward ratio (or risk-to-reward or reward-to-risk ratio, often expressed as R/R) is the ratio of maximum possible profit ("reward") and maximum possible loss ("risk") of an option position.
Using Option Risk-Reward Ratios
It is a simple, yet useful way of evaluating potential option trades. Generally, the higher the potential "reward" relative to the "risk", the better a potential trade is (other things being equal, which they never are – there are always tradeoffs, such as the distance of break-even prices).
The concept of risk-reward ratio is not limited to options or investing. You will also find it in business management, real estate, gambling, and generally any area where financial risk is involved.
How to Read and Write Risk-Reward Ratios
There is no single, unified way how risk-reward ratio is written and understood.
Let's explain the different R/R formats on an example: an option position which has maximum possible profit of $200 and maximum possible loss of $100. So the "reward" is 2x greater than the "risk".
Risk-reward ratio can be written in any of the following ways (and probably some more):
- 1:2 or 1/2 or 0.5:1 or 0.5/1 = risk to reward
- 0.5 = single number, meaning risk is this multiple of reward
- 2:1 or 2/1 = reward to risk
- 2 = single number, meaning reward is this multiple of risk
Unfortunately, different sources (software, websites) use different formats. There is no "correct" way, although the literal name "risk-reward" ratio favors the formats on the first (and perhaps the second) line above, while those on lines #3 and #4 would more accurately be called "reward-to-risk" ratio.
The likely reason why the reversed formats on line #3 and #4 are also popular is the convenient characteristic that higher (reward-to-risk) is better, while on the first two lines lower (risk-to-reward) is better.
How to Know Which Format Is Being Used
Because some positions have reward greater than risk and others have it the other way, there is no way to tell from the written risk-reward ratio alone which of the formats is being used. You need to know what the particular source (software, website) is using, rely on its documentation, support, or (when the other options are unavailable) try to decode the format from a position whose maximum profit and maximum loss you know.
Not All Option Positions Have R/R
Risk-reward ratio only makes sense when both profit and loss are
- possible and
In other words, only when reward is a finite positive profit and risk is a finite loss (negative P/L). A high number of option positions don't meet these criteria.
Some option position may be riskless (maximum possible loss is still a small profit) – for instance, some rare arbitrage situations, or positions which have been entered by legging in (entering the individual legs at different times) or rolling over from an earlier position (e.g. some calendar or diagonal spreads). Risk-reward ratio makes no sense.
Conversely, some option positions may be unable to turn profitable under any circumstances (maximum possible profit is still a small loss). This can again be a result of legging in or rolling over, although this time will less success. R/R makes no sense.
Some option positions have unlimited potential profit – generally positions which a long a greater number of call contracts than they are short, such as the plain and simple long call, long straddle or long strangle. We can say risk-reward ratio is infinite (or more precisely, reward-to-risk is infinite and risk-to-reward is infinitely small, or approches zero).
Other option positions have unlimited risk – generally those which are short more calls than they are long, such as short call, short straddle, or short strangle (generally the other side of the positions with unlimited profit). Here we can say reward-to-risk ratio is infinitely small or risk-to-reward is infinite.
Note: The unlimited profit or loss caused by unequal number of long and short call contracts does not apply to puts, as put option maximum profit is limited by underlying price falling to zero. Long put reward-to-risk may be very high, but not infinite.
Option Risk-Reward Ratio Calculation
While the different formats of risk-reward ratio may be confusing, its calculation is very simple. You only need to calculate maximum possible profit and maximum possible loss of a position, and divide one by the other.
Or you can calculate all in the Option Strategy Payoff Calculator.