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As I stated in my last post, I want to discuss the mathematics behind the madness of options trading and why options are the only investment tool that offers investors a probability of success over 50%, and in many cases, over 80%.
Probability is basically common sense reduced to calculation.
We use this statistical tool in so many aspects of our lives. Probabilities have become a tool of fundamental importance to nearly all scientists, engineers, medical practitioners and industrialists.
When your team has a coin toss before the game, you have a 50/50 chance of winning the coin toss. A basketball player steps up to the free throw line and has a good idea, based on past performance, whether he’ll make the shot. A football team tries for a field goal when they think the distance to the goal is close enough that they’ll likely make it.
More importantly, if you are told you need surgery, you’ll want to know the success rate of the operation. Based upon the statistics, you can make an informed decision whether or not it’s a good choice for you. You might decide whether or not to begin a course of medication, based on other patients’ positive outcomes or side effects.
These are just a few more examples of how probability plays a part in our lives.
Unfortunately, when it comes to the market, many investors don’t use common sense and ignore the probable.
Let me explain using an options chain of the Russell 2000 ETF (IWM).
As you can see in the chart above IWM is trading for $105.18 and according to the indicator at below the chart the underlying ETF is oversold (I will go over overbought/oversold and how I use them to enter/exit/monitor trades in a later post).
If an indicator is reading oversold in a highly-liquid ETF I follow, in most cases mean-reversion will take over and the underlying ETF will begin to move in the opposite direction or at least take a reprieve from the current trend.
So with that being said, I want to use a strategy that best accommodates a push higher, or at least not move significantly lower, over the next 25-45 days.
I’m not going to get into the details of the strategy here as I want you to concentrate on the probabilities at the moment. We will get into the strategies in the coming days. But, we need to learn to walk before we can run so…
The column on the far right labeled Prob.OTM states the chance IWM closes at or above a specific strike at November expiration in 42 days. As IWM moves incrementally lower from 105 to as low as 88 the percentages increase. It makes sense, right? With only 42 days left until expiration there is a greater chance of IWM reaching 104 than 88.
This is where common sense takes a turn for the worse…at least for the speculators.
Speculators are willing to take an 18% chance that IWM will close below 96 at options expiration in November. Before I go any further how do I get 18%? Simply take the Prob.OTM of 82.18%, or for simplicity’s sake 82% and subtract from 100%.
Fortunately for us, we are able to sell them the November 96 puts for $0.84, with a probability of success of 82.18%.
Moreover, we have the ability to increase our probability of success even further by choosing to sell speculators a strike further out-of-the-money.
For instance, we could sell them the November 95 strike for $0.72 with roughly an 84.35% probability of success or the 93 strike for $0.52 with approximately an 88.11% probability of success.
It is just common sense investing. We are simply using probabilities to our advantage. Yes, the terminology might be different than what you are accustomed to, but with a little hard work you can quickly overcome the basics for the opportunity to reliably bring in safe, consistent profits.
We’ll keep with this theme for a few more posts as it is very important to understand the concept of probability and how this statistical tool can work to our advantage when options trading.
If you would like even more ideas regarding options trading, don’t forget to sign up for my free weekly options report, The Strike Price. You’ll find everything options and more. Best of all it is delivered directly to you.
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