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As an investor, I love simple.
Some people 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 to them … and certainly don't buy into any such load of bunk!
Take options, for example. Yes, a lot of people – maybe even your stockbroker – will tell you options are too complicated and confusing. What they’re probably telling you is that they don’t want to understand options, so they don't want you to trade them either!
Yes, lots of people have joined the ranks of options traders. But only 10 years ago, just a privileged few investors 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. They were traded only by 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 in the same position as the Wall Street fat cats during their heyday just a few short years ago.
So now that we as self-directed investors have access to the same technology as professional traders, why aren't we applying this technology in the same way?
We all know that buying a stock or ETF has only a 50/50 statistical chance of success. But most investors don't know that they can increase the statistical chance of success well above 50/50. Professional traders do, and they have been using powerful technology to assist them with an appropriate strategy for years. But now you and I have the same technology. Now it’s up to use it to our advantage.
One of the more powerful tools offered in today's options trading software is option theoreticals. Probability of Expiring is the most informative data point among the options theoretical and one that I employ every day for my Options Advantage readers.
What is Probability of Expiring? It’s the chance a stock will close in the money at options expiration.
So the real question is … how can you use Probability of Expiring to your advantage?
Say, I believe that the Russell 2000 ETF (IWM) is currently in a short-term overbought state and the market is due for a short to intermediate-term correction. As a result, I want to place a trade that has roughly an 85% probability of expiring, or as I like to refer it as an 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.
Just look above and you will notice that how delta relates to the probability of success. Basically to find the probability of success you just take 100 minus the delta.
So, let's look at how we can apply probability of success to the real world.
IWM has pushed to new highs is currently in a short to intermediate-term overbought state. Moreover, we are entering the "sell in May" period.
With that being said, I want to place a bearish trade with defined risk and close to an 85% chance of success.
A bear call spread fits the bill.
As seen in the option chain above the 98 calls have a probability of expiring out of the money (OTM) of 83.41%. That means there was a 16.59% chance that IWM will close below 98 at June options expiration. In other words, the trade has roughly an 85% chance of success. You want the credit spread to expire worthless by not pushing above the 98 strike.
A theoretical trade: 98/100 bear call spread for $0.29 (.52 – .23) for a return of 16.9% if the trade closed at or below $98.
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 your probability of success? Sometimes yes, sometimes no – it truly depends on your risk profile and conviction.
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.
To learn more about capturing 77% probability on all of your option trades, WATCH my FREE Special Webinar this Thursday.