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In investing, absolutely nothing is more important than discipline and careful risk management.
This fact is particularly true when using options, because options offer an enormous array of strategies coupled with a huge amount of potential leverage. Essentially, an investor can purchase the right to a large portfolio with a comparatively small capital outlay.
The typical investor doesn’t understand the true concept of leverage. In fact, the average self-directed investor takes on far greater risks than he or she probably realizes. Yes, the rewards can be amplified, but so can the risks.
But we aren’t average investors.
We understand the importance of thinking in probabilities and how it allows us to define our own risk. We understand the risk associated with each and every investment in our portfolio. Lastly, we follow a few simple guidelines to lay the groundwork necessary to prudently build wealth using options. Here are a few ground rules to follow:
· Always think in probabilities
· View options as an investment, not a trade
· View options from a portfolio perspective
· Allow time to work for you
· Understand how options impact your overall portfolio
Always Think in Probabilities
Do you think about probabilities on each and every investment you make? You should.
Why can’t financial analysts simply tell me the likelihood that a stock will meet their expected price targets among the many pages of their detailed research reports?
Instead, the actual “pros” in the stock-picking business give you a buy target without providing the probability that the target will actually get hit. That’s amazing to me.
The analysis coming out of Wall Street’s best has nothing to do with the actual likelihood of success. Wall Street analysts are little better than Vegas bookies.
Think about it: A stock goes either up or down, so your probability of success is always 50%. It’s essentially a coin toss.
I’m simply not interested in analyst estimates. And if you want to make money in the markets, I think you’d be best advised to ignore analysts. That’s because a price target is just a guess, in my opinion. And I’m not interested in guesses.
I want to hear that the statistical chance of the stock going to $50 is X%, the chance of the stock going to $50 in three months is Y%, or the stock moving lower over the course of the next year is Z%.
That’s the type of precise advice I can use. And guess what: the options markets provide me with that information.
An Introduction to Probabilities of Success
Once you’ve found a highly-liquid ETF in an extreme overbought/oversold state, you can begin to look for a high-probability trade.
But before I get into the heavy stuff, let me start out with some obligatory technical mumbo jumbo and then I will get to an example that should hopefully help to clear things up.
Probability of expiring: The “probability of expiring” reflects whether an underlying stock’s price is above or below a strike price at expiration.
An underlying stock will either finish out of the money or in the money, so there are two possible scenarios for probability of expiring: probability of expiring in the money or probability of expiring out of the money (Prob.OTM).
Remember, we want to keep it simple, so let’s focus on what matters – probability of expiring out-of-the-money.
Probability of expiring out of the money is the chance that a strike price will close at expiration below an underlying stock price for calls and above an underlying stock price for puts.
My trading software – Thinkorswim – offers this helpful tool, but for those of you who do not have a platform that offers Prob.ITM you can just use the delta of an option, as it is roughly the same percentage.
I will explain in a moment why it is so valuable to know the Prob.OTM. Again, before I get to the nitty-gritty, let me explain “probability of touching” (Prob.Touch).
Probability of touching considers the possibility of the stock hitting (touching) the strike price at any time between now and expiration.
Again, I realize that some of you do not have access to trading software that gives you the probability of touching either, but any worthy trading software will provide you with the delta of any given option. And the Prob.Touch is simply double the delta.
So, the real question is, how can we use Prob.OTM and Prob.Touch to our advantage? Look at the chart below.
At the time I wrote up this example the price of the SPDR S&P 500 ETF (NYSEArca: SPY) was trading at $281.58. My assumption was that the S&P 500 would not move above $290 over the next 43 days.
This is where it gets interesting.
Because I think SPY will close below the price of $290 over the next 43 days, I want to choose a strike that had a Prob.OTM that is at least above 65%, and in almost all cases higher. I prefer 80%.
Look at the strikes below for SPY call options to see what qualifies – 290 and above. The strike price of SPY 290 has a Prob.OTM of 80.75%.
That means that that if I sell a call vertical, otherwise known as a bear call spread, I might sell the 290 call strike and buy perhaps the 293 strike. The trade would have a probability of success (also known as the Prob.OTM) of 80.75%. Extrapolate the 80.75% out 100 trades or 1,000 trades and you begin to see the value of using options strategies with a high Prob.OTM.
But what about Prob.Touch? How does that factor into all of this probability madness? Prob. Touch should be viewed as the potential stress level of a particular trade.
In our case, if we sold the SPY March 18 290/293 bear call spread, the underlying ETF would have a 39.38% chance of touching our short strike of 290. I like that percentage because there is still a low probability that SPY will “touch” my short strike and a 24.39% of touching my long strike of 293, which is my max loss level on the trade. This is invaluable information because it gives you a good idea of how stressful the trade will be.
Most newbie traders don’t think about the importance of probabilities. Always remember – you want to take emotions out of the equation. One way to do this is position sizing, which should ALWAYS be considered with each and every trade. But the other way is to keep your Prob.Touch below 50%, and preferably below 30%.
I know this is a lot to grasp, but again, these are the strategies that are revolutionizing how self-directed investors (like you and me) think about investing. The movement has already begun – so don’t be left behind.
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