There is a reason why out-of-the-money options are so cheap; it’s the equivalent of buying a lottery ticket. And gamblers love lottery tickets.
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.
In the options world the gambler is defined by a trader who buys a call or put with a delta of .35 and below. (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 options to 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 SPY strike closing in the money. In this case, the short strike of Mar13 156 has only a 15.52% chance to close in the money, or above the 156 strike, at March expiration. Notice the delta of the Mar13 156 strike is 0.16, or basically the same as the probability of expiring in-the-money.
So with 41 days left until March expiration, we have roughly an 85% chance of success. Remember, we make money with a credit spread when the options contracts expire worthless. Keeping close tabs on the Probability of Success or Probability of Touching (will discuss in a later post) is a great way to monitor your credit spread position and one of the best ways to choose a trade that fits your risk profile.
I’ve also talked before about the importance of position sizing. Using delta to calculate your success probability will help you make intelligent choices about your position sizes.
For instance, even with an 85% success probability, you wouldn’t ever want to risk all of your funds, or even half or a quarter of your funds.
That 16% 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.
If you haven’t, join my Twitter feed or Facebook. Also, I have officially opened up my strategies to the public. If you are a believer in a statistical approach towards investing please do not hesitate to try one of my options strategies. I use simple mean-reversion coupled with probabilities for each and every trade. Give it a try, it’s free for 30 days.