The Biggest Leap In My Trading Career

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Trading often appeals to impulsive people, to gamblers, and to those who feel that the world owes them a living. If you trade for excitement, you are liable to take trades with bad odds and accept unnecessary risks. The markets are unforgiving, and emotional trading always results in losses.

– Alexander Elder (Trading for a Living)

I love Mr. Elder's quote. It embodies the typical retail options trader. Why do you think the most popular options strategy among retail options traders consists of buying out-of-the-money straight calls and puts?

There is a reason why out-of-the-money options are so cheap; it's because they are the equivalent of buying a lottery ticket. And gamblers love lottery tickets. Look no further than the hype around the latest Powerball jackpot.

But unlike the typical lottery system where the seller of the ticket pays only a small portion of the overall proceeds in the form of winnings, options are a zero-sum game in the truest sense of the definition – winner's profits are loser's losses. And the majority of loser's losses typically come in the form of speculative out-of-the-money plays.

The winners know how to skew the results. Moreover, they know the risk-reward and the probability of success BEFORE each trade.

Which takes me back to Mr. Elder's quote about speculators who trade with bad odds. In the options world the gambler is defined by a trader who buys a call or put with a delta of .35 and below. (Remember, delta is the probability that an option will expire in the money.)

Like lottery tickets in the store, options with deltas this low have a low probability of success. But because of their cheap price and high-profit potential, they lure in newbie options traders.

This is why I prefer to take the other side in this zero-sum game. I do so by essentially taking the other side of the trade – by selling optionsto the speculative crowd.

Yes, I sell options with deltas of .35 and lower. Why is that significant? Because my probability of success starts at 65% (100-35) and moves higher as I sell further out-of-the-money options. For instance, if I sell an option with a delta of .15, my probability of success on the trade is 85%.

Delta is the first "Greek" that most traders learn about when they get started with options. Most people learn that delta tells us how much the price of an option will change if the underlying stock or ETF changes by $1.00.

For example, if you own a call option with a delta of .50, every $1.00 increase in the stock or ETF equates to a $0.50 increase in the price of the option.

But when trading credit spreads, the most useful way to think about delta is the probability of success for your trade.

Let me explain.

As you can see below, the trading software that I use (ThinkorSwim platform) tells me the probability of success or probability of the strike closing in the money. In this case, the short strike of Jan13 86 has only a 15.85% chance to close in the money, or above the 86 strike, at January expiration. Notice the delta of the Jan13 86 strike is 0.17, or basically the same as the probability of expiring in-the-money.

(click to enlarge)

So with 49 days left until January expiration, we have roughly an 84.2% (100-15.85) chance of success. Remember, we make money with a credit spread when the options contracts expire worthless. Keeping close tabs on the Prob. Exp. in-the-money and out-of-the-money are great ways to monitor your credit spread position and one of the best ways to choose a trade that fits your risk profile.

I've talked before about the importance of position sizing. Using delta to calculate your probability of success will help you make intelligent choices about your position sizes.

For instance, even with an 84.2% probability of success, you wouldn't ever want to risk all of your funds, or even half or a quarter of your funds.

That 15.85% probability that you'll lose money should make you acutely aware of how much you're risking, and how much you could lose should the trade go against you.

Keeping position sizing in mind along with the probability of success will keep you in the game for the long haul. And that's the only way you're going to have sustainable success as an options trader.

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