It may come as some surprise to you, but one quote stands above all others in helping me narrow my focus on my ideal options selling strategies.
This quote didn’t come from Benjamin Graham, Warren Buffett, or any investing guru. Instead, it came from former U.K. Prime Minister, Benjamin Disraeli. He said, “the secret to success is constancy to purpose.”
Prior to coming across Disraeli’s quote, I was just a wide-eyed neophyte that knew just enough about options to be dangerous. I thought I had a thoroughly tested trading plan. And of course, I was disciplined enough to stick with my plan while consistently generating profits. At least I thought so. Huge winners, here we come!
But then, as with many novice traders, losers start to pile up and my emotions took over. You see, I thought I was a “big” risk taker. I thought I could swing for the fences time and time again, without recourse.
My early and occasional winners only fed my appetite. It made me delusional and emotional, with massive highs when a winning trade hit and cratering lows when I stacked up losses.
Thankfully, early in my career, I came across some wonderful and encouraging mentors that continued to teach me the importance of exactly what Disraeli spoke about 150 years prior, “constancy to purpose.”
So, I dug in deeper, researching the risk and rewards of various options strategies to try and figure out where I fell on the “risk tolerance” spectrum. I certainly was way too stubborn and challenged to let my efforts go by the wayside. And admittedly, it took a while to figure out my level of aggressiveness, but time and time again all my efforts led me to a variety of conservative options selling strategies.
But it wasn’t just the conservative options selling strategies that suited my style of trading, I wanted to couple the strategies with a high-probability approach. With a background in statistics, I understood the Law of Large Numbers. I understood that as my sample size increased (in my case trades), my winning percentage would eventually fall right around my expected value. And since I was making trades that had an 80% to 90% probability of success, I should expect to see a high win rate.
However, let’s not be mistaken. Just because I am using a high-probability approach where each and every trade has an 80% to 90% probability of success it doesn’t mean that the approach is profitable over the long term. That would be way too easy, right? Which is where having an insatiable appetite for risk management comes into play. I quickly realized that to become a successful trader over the long term, I must see myself as a risk manager first, trader second. Because the true success of any trading strategy comes with the mechanics of how you handle risk through proper position size and disciplined stop-loss levels.
Hitting singles and the occasional double would be my approach in perpetuity.
After much reflection, I finally came to the realization that I was a trader that needed greater consistency in my wins, even if that meant sacrificing the benefits of an occasional homerun. I wanted the ability to generate steady returns in a more predictable fashion. Ultimately, taking a more conservative, high-probability approach using a variety of options selling strategies that would allow me to generate steady returns in any market environment, bullish, bearish, or range-bound.
For example, let’s take a quick look at a high-probability trade I might make in today’s market using the strategies and risk management techniques mentioned above. Please note, because of the timing of publication, this is purely for illustrative purposes as market conditions can change significantly.
SPDR S&P 500 ETF (SPY)
With SPY trading for 413.98, let’s take a look at a bearish-leaning options selling strategy known as a bear call spread.
Focusing on the March 31 expiration, with 44 days until expiration, the SPY 437 call strike with an 85.8% probability of success is where I want to start. By choosing the 437 call strike, not only is our probability of success well over 80%, our margin of error is roughly 23 points (437 short call strike – 413.98). Basically, SPY can move as high as 437, or 5.5% and I still have the potential to make a nice profit on the trade. The short call strike is what defines my probability of success on the trade. It also helps to define my overall premium or return on the trade.
Once I’ve chosen my short call strike, in this case, the 437 call, I then proceed to look at a 3-strike-wide, 4-strike-wide and 5-strike-wide spread to buy.
The spread width of our bear call helps to define our risk on the trade. The smaller the width of the spread, the less capital required. When defining your position size, knowing the overall defined risk per trade is essential. Basically, my spread width and my premium increase as my chosen spread width increases.
For our example, let’s take a look at the 5-strike, 437/442 bear call spread.
Trade Example: 437/442 Bear Call Spread
Sell to open SPY March 31, 2023, 437 call
Buy to open SPY March 31, 2023, 442 call for a total net credit of roughly $0.74 or $74 per bear call spread
- Probability of Success: 85.8%
- Total net credit: $0.74, or $74 per bear call spread
- Total risk per spread: $4.26, or $426 per bear call spread
- Max Potential Return: 17.4%
As long as SPY stays below our 437 call strike at expiration, I have the potential to make 17.4% on the trade. In most cases, I will make slightly less, as the prudent move is to buy back the bear call spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit.
Since we sold the spread for $0.74, I want to buy it back when the price of my spread hits roughly $0.37 to $0.19. Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But taking off risk by locking in profits is never a bad decision and by doing so, we have the ability to take advantage of other opportunities the market has to offer.
Since we know how much we stand to make and lose prior to order entry we have the ability to precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level allows not only the Law of Large Numbers to work in your favor…it also allows you to sleep well at night.
I also tend to set a stop-loss that sits 1 to 2 times my original credit. In my example, I sold the 437/442 bear call spread for $0.74. If my spread reaches $1.50 to $2.25, I will exit the trade.
I had the honor to start my Quant Trader service at Cabot back in early June 2022 using the same high-probability approach and options strategies mentioned above. Since then, we have had the good fortune to have 19 out of 20 winning trades for a total return of 131.87%. There is no doubt we continue to be pleased with the results, especially considering the ongoing state of the volatile market.