In my latest webinar, “Create Your Own Odds: the High-Probability Strategy for Consistent and Easy Income” I discuss the most overlooked aspect in all of investing/trading……probabilities.
Probabilities permit the self-directed investor the ability to choose trades with a proper return on capital while creating a risk profile that suits each investor’s needs. Basically, when using options appropriately you are able to choose your own probability of success.
Trading stocks only has a probability of success of 50%. I harp on this statistic all the time, but for some reason self-directed investors can’t comprehend the magnitude of that number.
Below is the chance to have three profitable trades in a row given the probability of success.
The 33% represents the typical out-of-the-money trade that a retail options trader makes. As you can see the probability of success is already only 33% to start. So to try to successfully make that type of trade three times in a row…well, you are better off going to Vegas.
As for the 50% trade, that is your typical stock or futures trade, essentially a coin flip. To obtain three successful trades in a row you only have a 12.5% chance. Again, not good. It’s baffling why many investors/traders choose to participate in something that is statistically a loser from the onset. Yet, most investors choose this route. They choose to enter into something that is inherently a loser. It makes no sense.
Only when you get to a probability of success 85% and greater do you start to see the true advantages of using a probability of success for each and every trade you place.
Probability of Success
- Probability of Success = 90% 3 in a row = 72.9%
- Probability of Success = 85% 3 in a row = 61.4%
- Probability of Success = 68% 3 in a row = 31.4%
- Probability of Success = 50% 3 in a row = 12.5%
- Probability of Success = 33% 3 in a row = 3.6%
But again, most investors/traders ignore the advantage of investing with probabilities. And this is why most traders fail.
Let’s think about this further.
Flip a coin.
Heads = Winning trades.
Tails = Losing trades.
10 coins = win rate is theoretically 50%, but if you do this several times there is the possibility that the coin will land on heads 3 times, or three tails (30% to 70% range).
100 coins = range 40 heads or tails (40% to 60% range).
1000 coins = range 475 heads or tails (47.5% to 52.5%).
The above shows that if you take your chosen probability of success – say in our case 90% – and extrapolate it out 1000 times your margin of error decreases significantly. Basically, the more you trade with a given probability of success the more likely that probability of success will come true over the long term.
So, just think about your typical stock trader or retail options trader that trades with a 50% or 33% probability of success. Over the long term those percentages will come to fruition and if you include transaction costs you can almost be assured that you will be fighting a losing battle.
So why do it? Why subject yourself to a strategy, or lack thereof, that is set up to fail? You know that the more you do it the more certain your expectations will match your probability of success.
The question is, if you know the outcome over the long term why are you not delving into strategies that allow you at least a starting point for success.
The financial industry would have you believe options are too difficult, too hard to understand. As a student of options for over 10 years I can tell you that is not true. Options are not difficult. Yes, you might have to think differently than you have in the past, but if that is what it takes to start using effective strategies with a statistical advantage then so be it.
Challenge yourself to be a better investor. Think differently from the herd.
What allows for options strategies with such a high probability of success?
In the probability of success chart above most retail options traders take on directional out-of-the-money positions with a 33% chance or below.
For the most part, unlike stocks, options are a zero-sum game. So, if there is an investor/trader out there willing to take on a position with only a 33% probability of success, the other side (my preferred side) has a 67% or higher probability of success.
I prefer to take this a step further and take on the opposing side of an investor/trader who is willing to buy a deep out-of-the-money option in hopes of hitting a home run. I start at 80%, but often move towards 85% to 90%. Why do I do this? Because the probability of success for the trade is 85% or higher and I ALWAYS want probability on my side.
As always, if you have and questions please do not hesitate to email me at [email protected].
Editor and Chief Options Strategist