The Beauty of Trading with High-Probability Credit Spreads

high-probability-credit-spreads

The Statistical Truth

I hate to say this about some of my fellow options traders, but I can’t tell you how much I abhor those in the industry that absolutely ruin the true benefits of options for the self-directed investor.

Claims of outlandish 300%, 400%, 1,200% in just a few days, without even a small discussion on the risks of the trade. Encouraging the use of low-probability out-of-the-money puts as a predominant strategy without the mention of selling premium. And I’m not saying selling premium is the only way to make consistent returns using options. In fact, I know numerous professional traders who have made a good living predominantly buying options … but they are few and far between. But what I am saying is that consistent returns at those levels just isn’t realistic. Yes, they will happen from time to time, but they are indeed the anomaly and shouldn’t be the basis for a sustainable trading approach.

It’s frustrating. It’s frustrating to see so many so-called gurus with no real-world experience act as options traders when their services fail time and time again.

For some reason investors don’t crave what’s truly important, realistic strategies with realistic gains. Transparency. Knowing that trading isn’t easy and is a life-long endeavor. And that while the journey may be bumpy at times over the long haul, it is worth all of the effort. A long-term approach focusing on short- to intermediate-term trading with high-probability trades as its foundation. Selling premium or buying premium based on levels of volatility. Always talking about the importance of position-sizing. Always considering risk management.

Why would people rather join services that tout such outlandish claims? It is beyond me. Are self-directed investors really that gullible? Why do they continue to fight statistics?

It is my hope that I have carved and will continue to carve a slice of decency and transparency into the options world. I am certainly not perfect, but I know that selling options is a valuable strategy with an overwhelming statistical advantage. And it is my goal to teach as many self-directed investors as I can about the benefits they offer.

Use Probabilities Now!

Some people will try to take a simple concept and sprinkle it with some mumbo jumbo to make it seem complicated and then claim only they can explain it to you! Don’t listen or don’t buy into any such load of bunk!

Take options. Yes, a lot of people, maybe even your stockbroker, will tell you options are too complicated and confusing. What they may really be telling you is options are something they don’t want to spend the time to understand, so they don’t want you to trade them either!

It was only twenty years ago that there were only a privileged few investors who could take advantage of things like streaming quotes and real-time options chains. Options were shrouded in mystery and deemed too complex for the average Joe—to be traded only by the so-called “sophisticated” professional investors.

Since then, however, seismic changes in the options world have leveled the playing field for individual traders and investors. Thanks to advances in technology, innovative trading tools, and better access to what was once privileged information, the self-directed investor is now equipped with the ability to trade like a professional options trader.

So, now that we as self-directed investors have the same technology as professional traders why aren’t we applying the technology in the same way?

We all know that a stock or ETF only has a 50/50 statistical chance of success. That’s right, no better than a coin flip. But what most self-directed investors don’t know is that there is a way to increase the statistical chance of success to well above 50/50. Professional options traders do, and they have been using powerful, statistically based strategies for years. But, as I stated before, now we have the same technology. Now it is up to us to use it to our advantage.

If I could choose one of the more powerful tools offered in today’s options trading software it would be the option theoreticals offered. Probability of Expiring (ITM or OTM) offers some of the most informative data point among the options theoreticals and one that I employ every day for my readers at Crowder Options.

The Power of Probabilities

Probability of Expiring OTM is the chance that a stock will close out-of-the-money at options expiration.

So, the real question is, how can you use Probability of Expiring (OTM and ITM) to your advantage?

Say I believe that the SPDR S&P 500 ETF (SPY) is currently in a short-term overbought state and the market is due for a selloff and I want to place a trade that has roughly an 85% probability of expiring out-of-the-money, or 85% probability of success.

I realize that some of you do not have access to trading software that gives you the probability of success, but any worthy trading software will provide you with the delta of any given option at each strike price.

high-probability-credit-spreads-SPY

Just look above and you will notice that delta is simply the probability of expiring out-of-the-money subtracted from 100. It’s not exact, but certainly close enough to make an informed decision.

So, let’s look at how we can apply probability of expiring out-of-the-money or delta to the real world.

Hypothetically speaking, since SPY is in an overbought state, I want to place a defined-risk, bearish trade with an 85% chance of expiring out of the money.

A bear call spread fits the bill.

As seen in the option chain above, the 463 calls have an 85.83% probability of expiring out-of-the-money. That means there is only just under a 15% chance that SPY will close above 463 at November options expiration.

I could sell the 463/466 bear call spread for roughly $0.47. A return of 18.6% if the trade closed below $463 at November expiration.

Not bad for a trade that has an 85% probability of success.

If you choose a trade with a lower probability of success, such as 68% you will be able to bring in more premium with less capital at risk. But it is important to realize that when you give up probability for premium your chance of success declines.

Simply stated, the greater the risk, the greater the gain. You must always take that into consideration because … is it worth making an extra 10% to give up 20% in your probability of success? Sometimes yes, sometimes no—it truly depends on your risk profile and conviction. In my case, I always side with probabilities. I want consistent income and consistent returns. I don’t want the stress involved with lower probability trades. It just doesn’t make sense from a statistical standpoint.

There is no doubt that we’re at a special time in history. I think we’ll see statistically based trading absolutely explode over the coming decade. Early adopters like you and I will be sitting in the driver’s seat as wave after wave of novice options investors come into the fold.

10 comments on “The Beauty of Trading with High-Probability Credit Spreads

  1. aba shelra on

    One point which is missing is that the loose size is larger than the win size. Actually, the expected return (mean) of any option should be “0”. Otherwise, assuming the market is efficient, the price will change such that the mean will be “0”. So how people are making money 1) they bet successfully on a direction for the market. 2) when selling options they allow the buyer to reduce his risk for a fee that goes to that seller.

    Reply
    • Andy Crowder on

      Aba,

      Thanks for the question.Quantitative strategies are all based on hard statistics, like probabilities. Probabilities work, but you must be disciplined to allow the law of large numbers to work in your favor. Successful professional traders have been using probabilities for decades…and it’s the foundation, along with proper risk-management that leads to long-term success…and that’s the only thing that matters.Ultimately, when trading based on probabilities it’s a matter of allowing the law of large numbers to do the heavy lifting. So, sequence risk will come into play occasionally. It’s all about building those occurrences so the expected value, in this case, the 80% probability of success, can work out. Moreover, when thinking about the vertical spread in the example, it’s not a straight 80%/20% (win/loss), right? The 20% is based on a max loss calculation and most of the time max losses do no occur, either due to the underlying strike not reaching a max los state, or because sound risk-management techniques come into play (adjusting, stop-loss). Plus, it is important to remember, the probability is actually less at the long strike. Either way, professionals have been using vertical spreads successfully for years. It’s a wonderful strategy. But like any strategy, it isn’t foolproof. Which is why I always teach that to be a truly successful options trader you must diversify your approach among a basket of different options strategies that take advantage of different types of market environments (bullish, bearish, neutral). I hope this helps and thanks again for the question.

      Reply
    • Andy Crowder on

      Fred,

      Thanks for the question. There are plenty of choices out there, but I can only speak to what I am comfortable using and that is the Thinkorswim platform and the Tastyworks platform. Both offer lots of wonderful tools, etc. for options traders and investors alike. I hope this helps.

      Reply
  2. Ahmad Mohammad on

    A very true and valuable discussion in this article. Why many new as well as experienced option traders are not using these probability based option trading methods? Perhaps it is because of the general impression, as you wrote early in this article, is that they do believe that options can quickly gratify them by profits of 100%, 200% or more in a short time by buying cheap OTM call options on rising stocks. They are not interested in small dollar prmiums of $0.25, $or even $1.50 or more and do not like to waite for the premiums to dissipate through time for the decay of premium to make the profits over the duration of option trades. I have often experienced losses on bear call spreads because as the price of the underlying goes up the shorted premium also goes up very rapidly and often becomes 150 -200% of the orignial received, even though the underlying will still be under the short call strike price. One must find out, what is the relationship between rising stock prices and rising short call option premiums? Another question, I have is what are the stop limits for sold credit spreads? At what percentage loss of the premium, one should close the trade? For example, for stock purchases usually 20-25% loss in the stock price is the stop loss point at which to close the trade. Will greatly appreciate your insights and responses. Thanks, Ahmad

    Reply
    • Andy Crowder on

      Lots of people speculate suing options and that’s fine, but those that trade for a living take a more mathematical approach to trading, using statistics and probabilities to their advantage. If you are using high-probability bear call spreads you should not be seeing the spread move up in value quickly if it moves against to you. The reason is because the overall delta of the spread is small. That’s the beauty of high-probability credit spreads, you can be completely wrong on your assumption and still make a profit on the trade. As for stop-losses, I typically go 1 to 2 times the original credit. I hope this helps.

      Reply
  3. David Rosenfield on

    But, as you know the delta is differtent every day. The delta at the beginning of the trade, if it goes against you, will not be the same with the stock price surging. So your solution is to put a stop/loss on the short side of the trade or sell the entire spread.

    Reply
    • Andy Crowder on

      David,

      I’m not quite sure what you are referencing, but let me take a swing at your question/comment. Yes, delta is different every day. But we know exactly what out delta is at the start and it is at the beginning of the trade, actually prior to making the trade, where we make our risk management plan. Risk management starts with position-size. That is the most important aspect of risk management. Next is a stop-loss, if you so choose to have one. I prefer to use a stop-loss (always mental) that allows me to get out of a trade 1 to 2 times the original premium. I also pay attention to the delta of the spread. Once my short strike goes from say 0.10 to 0.20, to say 0.30 to 0.35, even 0.40, I look to roll the untested side to bring in more premium and thereby lower the cost basis/risk of the overall trade. I typically get out of the entire spread once I go through this process. Hope this helps.

      Reply

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