A Statistical Approach to Outperforming the Market

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What would you buy now?

Seriously?  Is that a question that we, as self-directed investors should have to answer. Yet the question is asked everyday in almost every financial media outlet. And most of the answers lack depth and sound reason. Moreover, the probability of choosing a successful stock is always 50/50. Why do you think monkeys throwing darts at the WSJ stock section performed almost as well as the professionals. Remember, it's a game that is controlled by marketing. Think about it. The message is so powerful on the major media outlets that they, the media, actually make you think the financial professionals that grace their airwaves and their respective companies can outperform the market. Yet, look at the facts 

 

Randomly choosing stocks without an overall vision of a strategy or strategies is futile. An endeavor that makes no sense to me and one that has a low probability of success.

 

What is a logical, practical mix of various investment/trading strategies should be the question asked by investors. But, don't confuse a diversified basket of stocks as an actual strategy. A basket of stocks is only a form of exposure to the market, not a strategy.

 

A  strategy is a logical, practical, mathematically sound approach that focuses on taking advantage of various nuances in the market. Whether they be mean-reversion strategies, gap fade strategies, a combination of various options trading strategies or even some form of a momentum based strategies. It doesn't really matter. What matters is that the combination of strategies must have a probability of success that makes sense. And when I say "makes sense" I mean that it must have a probability of success that makes sense  and contains a risk/reward that makes sense given your risk tolerance.

 

For instance, take a bull put spread. An options strategy where based on my risk tolerance I can choose my own probability of success. Yes, that's right I can choose my own probability of success.

 

Let me explain.

 

I'll use SPY as my underlying.

 

SPY March 2012 Options Chain (Calls) 

 

 

 

  • SPY trading at $131.83
With SPY trading at $131.83 I want to choose a strike that meets my risk/return objectives.
 
I prefer to put a little more on the table to gain a higher probability of success, because ultimately you want a successful trade. Yes, I could try to bring more money in by selling a strike that is closer to the current price of SPY. But this lowers my probability of success. Don't forget, the ultimate goal is to increase your probability of success while at the same time taking on risk that allows for a return that is suitable for your income goals.
 
Again, this is how I trade in the Theta Driver strategy. 
 
Mine sits between the 70% – 90% range. 
 
For instance, I like the 138/140 bear call spread or the 139/141 bear call spread.
 
Both have a high-probability of success (100 – 17.52 = 82.5%) (100-13.70 = 86.3%).
 
As long as SPY does not exceed my short strike of say 139, the trade is successful. 
 
A like to have a decent margin for error , which obviously increases my probability of success, and the 139 strike allows for a 5.4% cushion to the upside. So, SPY would have to move above 139 for the trade to start losing value. As long as SPY stays below 139 through March options expiration the trade is successful. 
 
Credit spreads are my favorite way to trade options, particularly selling verticals. It's an extremely simple strategy to learn and arguably the most powerful strategy in the professional options traders toolbelt.
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