Back in the early part of the 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 every one.
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 ten 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 technology, innovation 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 were during their heyday – just a few short years ago.
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. 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 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.
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 is the most informative data point among the options theoreticals.
Probability of Expiring is the chance that a stock will close in-the-money at options expiration.
So, the real question is, how can we use Probability of Expiring to our advantage?
Say, I believe that SPY is currently in a short-term oversold state and the market is due for a bounce and I want to place a trade that has roughly an 85% probability of expiring, or as I like to refer it as the 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 close the delta is 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 lows and is currently in a short-term oversold state. Moreover, the last two weeks of December are historically bullish.
With that being said, I want to place a bullish trade with defined risk and an 85% chance of expiring out of the money.
A bull put spread sounds about right.
As seen in the option chain above the 110 puts have a probability of expiring of 15.59%. That means there is a 15% chance that SPY will close below 110 at January options expiration. In other words, the trade has an 85% chance of success because you want a credit spread to expire worthless by not falling below the 110 strike.
You could sell the 110/108 bull put spread for $0.26 (.83 – .67) for a return of 14.9% If the trade closes at or above $110.
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 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 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.
Keep your eyes on the probability of success and together we'll grow our income in the coming years.
As always, if you have any questions please do not hesitate to email me at [email protected].