I have received numerous questions on the probabilties of
success. What is means, how it works. Hopefully the following
post answers a few of those pending questions.
Once you have 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 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 SPDR S&P
500 ETF (
SPY
) was trading at $131.50 and in an
overbought state
. My assumption based on the current overbought state of SPY was
the S&P 500 would move lower over the next 39 days (July
expiration).
This is where it gets interesting.
Because I thought SPY would close below its price of $131.50 I
wanted to choose a strike that had a Prob.OTM that is AT LEAST
above 50% and in almost all cases higher. I prefer 85%.
Look at the strikes below for SPY call options in July to see
what qualifies - 132 and above. The strike immediately above the
price $131.50 of SPY, 132, has a Prob.OTM of 50.87%.
That's not high enough for me. It is essentially a coin flip.
Again, I prefer something that has a higher Prob.OTM - say the
Jul12 139 strike, for instance. It has a Prob.OTM of 87.26%.
That means that that if I sell a call vertical, otherwise
known as a bear call spread, I might sell the 139 call strike and
buy maybe the 141 strike. The trade would have a probability of
success (also known as the Prob.OTM) of 87.27%. Extrapolate the
87% out 100 trades or 1000 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 Jul12 139/141 call spread, the
underlying ETF or SPY would have a 26.28% chance of touching our
short strike of 139. I like that percentage because there is
still a low probability that SPY will 'touch' my short strike.
This is invaluable information because it gives you a good idea
of how stressful the trade will be.
Just think if we decided to choose to short a strike with a
lower Prob.OTM, which inherently has a higher Prob.Touch, at say
the 135. Again, we want to use a bear call spread so we would
sell the 135/137. The 135 has a Prob.OTM or probability of
success of over 70%, which is still fairly high, considering a
stock trade only has a 50% chance of success.
But if you notice the Prob.Touch you will discover that the
probability is over 62%. That just means that while you still
have a good chance of the trade going in your favor, you should
expect to experience some stress with the trade.
Most newbie traders don't think about this important aspect.
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% 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.