Some people will try
to take a simple concept and sprinkle it with some mumbo jumbo to make it seem
complicated and then claim only they can explain it to you! Don't listen or
don't buy into any such load of bunk!
Take options. Yes, a
lot of people, maybe even your stockbroker, will tell you options are too
complicated and confusing. What they may really be telling you is options are
something they don't want to spend the time to understand, so they don't want
you to trade them either!
It was only ten
years ago, that a privileged few investors who could take advantage of things
like streaming quotes and real-time options chains. Options were shrouded in
mystery and deemed too complex for the average Joe – to be traded only by the
so-called "sophisticated" professional investors.
Since then, however,
seismic changes in the options world have leveled the playing field for
individual traders and investors. Thanks to advances in technology, innovative
trading tools, and better access to what was once privileged information, the
self-directed investor is now equipped with the ability to trade like a
professional options trader.
So, now that we as self-directed investors have the same
technology as professional traders why aren't we applying the technology in the
We all know that a
stock or ETF only has a 50/50 statistical chance of success. That's right, no
better than a coin flip. But, what most self-directed investors don't know is
that there is a way to increase the statistical chance of success to well above
50/50. Professional options traders do, and they have been using powerful,
statistically-based strategies for years. But, as I stated before, now we have
the same technology. Now it is up to us to use it to our advantage.
If I could choose
one of the more powerful tools offered in today's options trading software it
would be the option theoreticals offered. Probability of Expiring (ITM or OTM)
is the most informative data point among the options theoretical and one that I
employ every day for my readers at Crowder Options.
The Power of Probabilities
Expiring is the chance that a stock will close in-the-money at options
So, the real
question is, how can you use Probability of Expiring to your advantage?
Say, I believe that
the SPDR S&P 500 ETF (SPY) is currently in a short-term overbought state
and the market is due for a sell-off and I want to place a trade that has
roughly an 85% probability of expiring out-of-the-money, or as I like to refer
it as the probability of success.
I realize that some
of you do not have access to trading software that gives you the probability of
success, but any worthy trading software will provide you with the delta of any
Just look above and
you will notice that how delta the probability of expiring out-of-the-money
minus 100. The formula 100-delta = POE.
So, let's look at
how we can apply probability of expiring out-of-the-money or delta to the real
speaking, I want to place a defined-risk, bearish trade with an 85% chance of expiring
out of the money.
A bear call spread
fits the bill.
As seen in the
option chain above the 148 calls have a probability of expiring
out-of-the-money of 85.48%. That means there is only a 15% chance that SPY will
close above 148 at January options expiration. In other words, the trade has an
85% chance of success because you want a credit spread to expire worthless by
not climbing above the 148 strike.
I could sell the
148/150 bear call spread for roughly $0.25. A return of 14.3% if the trade
closed at or below $148 at January expiration.
Not bad for a trade
that has an 85% probability of success.
If you choose a
trade with a lower probability of success, such as 67% you will be able to
bring in more premium with less capital at risk. But, it is important to
realize that when you give up probability for premium your chance of success
Simply stated, the
greater the risk, the greater the gain. You must always take that into
consideration because…is it worth making an extra 10% to give up 20% in your
probability of success? Sometimes yes, sometimes no – it truly depends on your
risk profile and conviction. In my case, I always side with probabilities. I
want consistent income on a monthly basis. I don't want the stress involved
with lower probability trades. It just doesn't make sense in most cases.
No glitz or glam
here – just straight trading.
There is no doubt
that we're at a special time in history. I think we'll see statistically-based
trading absolutely explode over the coming decade. Early adopters like you and
I will be sitting in the driver's seat as wave after wave of novice options
investors come into the fold.
I am keeping it short
as I have lots to work on for the coming days. If you haven’t, please take the
time to join my Twitter feed or Facebook.
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