April 23, 2014

How to Choose Your Own Probability of Success

Quick Options Primer

I am often asked about how I come up with the probability of success percentage that I refer to in many of my reports and here on the blog.

For those of you new to the blog, I currently trade two options strategies (I hope to add a few more in the coming months). One of my strategies is a directional strategy using short-term overbought/oversold measures based on my high-probability, mean-reversion indicator. I play the strategy by using straight calls and puts.

The other strategy, and indeed my favorite, is the Theta Driver strategy where I sell out-of-the-money vertical spreads with a high probability of success.

So, what do I mean by a high-probability of success.

The answer is quite simple.

Take a look at the following options chain:

If you look at the far left side of the options chain you will notice a percentage-based number. This is the “probability of expiring” or the probability that the underlying, in this case SPY, will close above the given strike.

For example, if you look at the Mar12 140 strike you will notice that the probability of SPY expiring above 140 is only 20.77%. That means that if I sell this strike, the chance that SPY will close below the 140 strike is roughly 80% with only 25 days left until March expiration. The closer I move towards the at-the-money strike the lower my probability of success or the higher the probability of the underlying expiring above the chosen strike.

This is the one of the first steps in choosing which strikes to use for your credit spreads and arguably the most powerful number for the future of investing.

If your trading platform does not have options theoreticals, you can use the delta as an approximation. If you notice in the options chain for SPY delta is roughly the same as “probability of expiring”.

Again, I will discuss this further over the coming days, so stay tuned.

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