Options Trading: Profit and Probability, Part 3

Posted On December 18, 2017 1:39 pm

If the election results and market responses teach us anything, it’s to expect the unexpected and make sure your positions and portfolio can withstand the even the most outlandish of events. This is just as true in options trading as any other sector of the market.

In the first part of this series, we looked out how to properly measure risk and return for before even stepping in the batter’s box.  In the second part, we walked through the value creating the right risk/reward  to make sure you’re swinging at fat pitches.

In this installment, to further torture the analogy, I show how taking a walk to get on base is a crucial part of the game.

That is, there are some positions in which you don’t need to do much of anything, except exhibit patience, and you still get to first base.

I’m talking about positions in which are options are sold for a credit.  If the value of the options declines, a profit can be realized.  The profited is limited to the sale price or premium collected.  The maximum profit would be realized if the option expires worthless.

Typically credit positions involve puts, calls or a combination of both that have strikes that are out-of-the-money.  Meaning the options have no intrinsic value; their value is entirely comprised of premium.  In this sense the seller, or “writer” of options is acting like an insurance company; you collect the premium but you also assume the often risk of making a large payout or loss if there an adverse event.

To offset this inherently asymmetrical risk/reward profile, we need to create a situation that not only has a high probability of success, but also make sure we are collecting enough premium for the risk we are assuming.

The first and most important way we limit and manage our options trading risk is to never sell or short options naked.  That, is always use some form of a spread.  A typical credit spread involves selling a put or call and then buying a further out-of-the money put or call for a lower price.

An example of a basic credit put spread in Apple (AAPL) would be with shares trading $127, one could sell the $125 put for $3.00 a contract and buy the $120 put for $1.40 a contract.

This is a $1.60 net credit.  If Apple shares are above $125 on the expiration, all options expire worthless and the $1.60 maximum profit would be realized.  On the other hand if shares sink below $120 the maximum loss of $3.40 would be incurred.

So why would someone put on a position that can only make $1.60 but lose $3.60?  Because even if you were moderately wrong about your bullish outlook, and even Apple shares declined by up to $2 or 1.5%, you could still realize the maximum profit.  In fact, shares could drop by as much as $3.5 or 2.7% to $123.50 and a small profit could still be realized.

Compare this to buying a call option with the $125, which would currently cost $4.50 a contract. In this case you need shares of Apple to rise an additional $2.50 or be at $129.50 at expiration just to break even.

 Related: Profits and Probability, Part 1

Obviously the credit spread position has a much higher probability of achieving a profit.  To go back to the baseball analogy, credit spreads allow you to be the batter to the market’s pitcher, forcing it to do all the work by throwing strike after strike.

Tailwinds of Time & Volatility

Credit positions benefit primarily from time decay and a decline in implied volatility.  This makes them best suited for sideways or range bound markets, ones that exhibits a reliably steady trend or situations in which volatility levels have elevated to levels that are unlikely to persist.

To set up a position with a high probability of profitability and acceptable risk/reward profile, I use two basic parameters.

I want  at least 75% probability of a profit; that means choosing the inside or short strikes that have less than 25% probability of expiring in-the-money.   While many option chains will provide probabilities of expiration a basic rule of thumb is to look at delta. I’m using strikes with a 0.20 delta, meaning they have only 20% chance of being in-the-money on expiration.

I also want to achieve a 20% return on my risk capital.   That means there must be enough premium to generate sufficient income while marinating the limited risk of a spread.

The 75% Solution for Options Trading

While I have the probability of profit in my favor, I want to further manage risk. I use the basic rule of thumb that I should close positions once either 75% of profit has been realized, or a 75% loss was incurred.

For instance, in the original Apple example above, if shares quickly rallied above $130, the value of the put spread might decline to 40 cents way before the March expiration.  At this point I would look to close the position for a profit.

Conversely, an adverse move, such as we are experiencing in the SPY condor, if the value of the iron condor climbs to $2.02 I would close the position.

You can create a sliding scale along a time frame. For example, if a 50% profit could be realized within a matter of days, it may make sense to close the position.  If you’re suddenly facing a 50% loss, clearly something in your thesis of range bound or declining volatility environment was wrong, and it may be best to just vacate.

But no matter the time frame, if an option you’ve sold short has declined to less than $0.10 a contract, then buy it back and cover yourself. At that point, the risk/reward becomes too asymmetrical. Don’t try to squeezing out the last dime of premium, it would cost you multiple dollars.

To sum up this series on profit and profitability, I’ll say this: it’s important to understand how risk is measured, knowing how to identify the fat pitches, but also having the skills and patience to occasionally take a walk. Keep these things in mind, and your options trading will be smoother and more manageable.

 Related: Profit and Probability, Part 2

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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