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Back in the early 1900s, the automobile was strictly for the richest of the rich. It was an entirely new and novel invention and you basically couldn’t own one unless you had a large amount of money at your disposal.
But within a decade, that all changed. The automobile became the province of nearly everyone.
In 1900, only 8,000 automobiles were registered.
Within 10 years, that number increased by a factor of 39 and over 300,000 automobiles hit the roadways.
And by 1920, the number ballooned to 9.2 million automobiles.
Today, the options world is a lot like the automobile world of 1910. Yes, lots of people have joined the ranks of options traders. But only a few years ago, it was just 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 options technology, innovation trading tools, and better access to what was once privileged information, the individual investor is now in the same position as the Wall Street fat cats were during their heyday – just a few short years ago.
So, now that we as individual investors have the same options 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. But, what most 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 technology to assist them with an appropriate strategy for years. But, as I stated before, now we have the same technology. Now it is up to use it to our advantage because the strategies allow us to profit in bullish, bearish or sideways markets.
If I could choose one of the more powerful options technology tools offered in today’s options trading software it would be the option theoreticals offered. Probability OTM is the statistical chance an option will close out-of-the-money at its expiration date and is the most informative data point among the options theoreticals.
Probability OTM is the chance that a stock will close out-the-money at options expiration. It’s otherwise known as probability of success.
So, the real question is, how can we use this tool to our advantage?
An example: Say I believe that SPY is currently in a short-term overbought state and the market is due for a short-term reprieve and I want to place a trade that has roughly an 80% to 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…and the delta of an option is the inverse of the probability of success. For instance, a strike with a 20 delta will have a probability of success around 80%.
Just look above and you will notice the inverse relationship of the delta to the probability of success.
So, let’s look at how we can apply probability of expiring to the real world.
SPY has pushed to new highs and is currently in a short-term overbought state.
With that said, I want to place a bearish-leaning trade with defined risk and an 81% chance of success.
A bear call spread sounds about right.
As seen in the option chain above the 281 calls have a probability of success hovering above 81%. That means there is only a 19% chance that SPY will close above $281 at April options expiration in 43 days. In other words, the trade has an 81% chance of success because you want a credit spread to expire worthless by not pushing above the 281 strike.
If you choose a trade with a lower probability of success, such as 67% (right at one std. deviation or 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 probability of success? Sometimes yes, sometimes no – it truly depends on your risk profile and your conviction on each and every trade.
No glitz or glam here – just straight trading. Today, we’re at a special time in history. I think we’ll see options 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.
Keep your eyes on the probability of success and together we’ll grow our income in the coming years.