August 22, 2017

Short-Term Reversion to the Mean Underway?

With the exception of a few highly-liquid international ETFs that I follow, all of the participants in the High-Probability, Mean-Reversion Indicator pushed back into a neutral state yesterday.

The sell-off that began shortly after Big Ben spoke on Wednesday really gained momentum on Thursday and has given all of my credit spread positions some much needed breathing room. But, we should not look at the recent test of our short strikes as anomaly.

Remember, even though I begin most of my credit spread trades with a probability of success around 85%, the probability of actually touching my short strike is approximately half of my probability of success (or Prob OTM).

You could also look at it by taking the delta (in this case since we have a probability of success of 85% our delta would be roughly .15) and double that amount to get our probability of the underlying ETF touching the short strike. (I will go over an example in greater detail this weekend in my weekly report – Vertically-Inclined.) Basically, the “probability of touching” estimates the likelihood of the market reaching the strike price of an option prior to the expiration date.

The reason I point this out is because situations like what we just experienced (underlying touching the short strike of an out-of-the-money credit spread) on a probability basis is greater than the actual success of the trade. And that’s because the underlying’s price has to close in the money before the trade begins to take a loss. But again, the chance of that is only 15%. And that’s due to several things, one being if a underlying ETF is able to move let’s say 5%-8% over the course of 30-45 days, most likely the move is extended as it has most likely moved 1 to 2 standard deviations. And that is where the mean-reversion indicator kicks in.

Since I put on many of my positions the ETFs I follow have continued to trend higher and move further and further away from the mean thereby testing my short strikes. But again, this is why I use out-of-the-money credit spreads, because they allow me a margin of error on the trade. Basically, they allow for the probability of touching knowing that if the underlying happens to touch the short strike that a reversion to the mean should be underway shortly after. Of course, it doesn’t always work this way (nothing does), but I can tell you that more often that not this is exactly what occurs.

I’m certain I have confused a large portion of you, but I will discuss this more going forward as it truly is an important aspect in understanding exactly how credit spreads work.

If you haven’t, join my Twitter feed or Facebook. Most of all, make sure you sign-up for my Free weekly newsletter,Vertically-Inclined.