The Statistical Truth
I hate to say this about some of my fellow options traders, but I can’t tell you how much I abhor those in the industry that absolutely ruin the true benefits of options for the self-directed investor.
Claims of outlandish 300%, 400%, 1,200% in just a few days, without even a small discussion on the risks of the trade. Encouraging the use of low-probability out-of-the-money puts as a predominant strategy without the mention of selling premium. And I’m not saying selling premium is the only way to make consistent returns using options. In fact, I know numerous professional traders who have made a good living predominantly buying options … but they are few and far between. But what I am saying is that consistent returns at those levels just isn’t realistic. Yes, they will happen from time to time, but they are indeed the anomaly and shouldn’t be the basis for a sustainable trading approach.
It’s frustrating. It’s frustrating to see so many so-called gurus with no real-world experience act as options traders when their services fail time and time again.
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For some reason investors don’t crave what’s truly important, realistic strategies with realistic gains. Transparency. Knowing that trading isn’t easy and is a life-long endeavor. And that while the journey may be bumpy at times over the long haul, it is worth all of the effort. A long-term approach focusing on short- to intermediate-term trading with high-probability trades as its foundation. Selling premium or buying premium based on levels of volatility. Always talking about the importance of position-sizing. Always considering risk management.
Why would people rather join services that tout such outlandish claims? It is beyond me. Are self-directed investors really that gullible? Why do they continue to fight statistics?
It is my hope that I have carved and will continue to carve a slice of decency and transparency into the options world. I am certainly not perfect, but I know that selling options is a valuable strategy with an overwhelming statistical advantage. And it is my goal to teach as many self-directed investors as I can about the benefits they offer.
Use Probabilities Now!
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 twenty years ago that there were only 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 same way?
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) offers some of the most informative data point among the options theoreticals and one that I employ every day for my readers at Crowder Options.
The Power of Probabilities
Probability of Expiring OTM is the chance that a stock will close out-of-the-money at options expiration.
So, the real question is, how can you use Probability of Expiring (OTM and ITM) 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 selloff and I want to place a trade that has roughly an 85% probability of expiring out-of-the-money, or 85% 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 given option at each strike price.
Just look above and you will notice that delta is simply the probability of expiring out-of-the-money subtracted from 100. It’s not exact, but certainly close enough to make an informed decision.
So, let’s look at how we can apply probability of expiring out-of-the-money or delta to the real world.
Hypothetically speaking, since SPY is in an overbought state, 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 463 calls have an 85.83% probability of expiring out-of-the-money. That means there is only just under a 15% chance that SPY will close above 463 at November options expiration.
I could sell the 463/466 bear call spread for roughly $0.47. A return of 18.6% if the trade closed below $463 at November 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 68% 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 declines.
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 and consistent returns. I don’t want the stress involved with lower probability trades. It just doesn’t make sense from a statistical standpoint.
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.