Options Tip of the Week

Who is the better options trader?

A. Two Nobel Prize winning economists who founded the very model that options pricing is based on.

Or…

B. A guy who thinks the market is like a giant poker game.

Of course, A right? They are the geniuses. I mean they wrote the Black-Scholes options pricing model.

But, if you have ever read the book “When Genius Failed” you would quickly realize that the smartest people in the room are not the best investors/traders. In short, the two Nobel Prize winning economists, Myron Scholes and Robert Merton lost $4.7 billion dollars in four months. That’s billion with a B.

And while they were losing money, the trader who views the market as one big poker game was making billions – also with a B.

And he was doing it using probabilities. As I always say, it’s all about the probabilities.

His name Jeff Yass and he runs the most successful options trading firm in the world, Susquehanna Investment Group.

I mention poker because Mr. Yass values thinking in terms of probabilities and that is exactly what options and poker have in common – thinking in terms of probabilities.

Every professional options and poker professional will tell you the same thing – the longer you play with a negative edge, the greater the probability of eventual financial ruin. Probably the most basic requirement for successful trading is that you must have some well-defined method, or, in other words, a specific approach that gives you an edge.

That approach could be buying undervalued securities and selling overvalued securities or it could be some better-than-breakeven way of selecting price directional trades.

Without such a method, or edge, you will eventually lose, because the odds are 50/50 before transaction costs. If you don’t know what your method is, you don’t have one.

Which is why I trade credit spreads.

It gives me a defined edge.

It allows me to choose my own probability of success.

I will explain in The Trade Arena below.

 

The Trade Arena

ak1 the hottest stock on the planet right now – Apple (AAPL).

I could buy or sell the stock short right now, but my probability of success would only be 50%. The stock is either going to go up or down. Including my transaction costs my probability of success is actually lower than 50%.

However, through the use of credit spreads I can choose a much greater probability of success.

Just look at the options chain of AAPL below.

If you look at the Probability of Expiring you can choose your own probability of success. Take for instance the Mar12 530 calls – they have a 81% chance of success (100% – 19.17%). The Mar12 540 calls have an even higher probability of success at 86%.

The further away a strike is from the current price of the underlying stock the greater the probability that the strike will close out-of-the-money.

Basically, I am selling options to speculators – traders, most likely newbies, who are speculating that Apple will continue to surge past the 530 strike by March options expiration (35 days). The trade they have chosen to make has a probability of success of 19.17%. Those are odds that I would never take as a trader.

So let’s say I decided to place a bear call spread at the 530/535 strike – selling the 530 and buying the 535 (to keep my risk defined).

Apple would have to move 7.5% higher for the trade to be in jeopardy of taking a loss. So, I could be completely wrong in my assumption of Apple moving lower and yet I can still make a profit.

Why aren’t more and more investors using this strategy? It makes perfect mathematical sense. The odds are overwhelmingly in your favor.

This is what I do in the Options Advantage service and it is what I have been doing throughout my entire career as an options trader.

Yet, I am still amazed how many still insist on listening to talking heads or anyone for that matter on what stock to buy. Knowing that each and every choice only has 50/50 odds of success, it just doesn’t make sense why people keep perpetuating the guessing game that goes on daily in the investment world. Stop guessing and start using probabilities to make your decisions.

 

Strategy: Short call vertical (bear call spread)

Simultaneously: Sell the Mar12 530 calls & Buy the Mar12 535 calls for a credit of $$0.80.

Max Loss: $420 per contract

Max Profit: $80 per contract

Return: 19.0%

Probability of Profit: 80%

Expiration: 35 days

Consider paper trading the idea above. I know you’ll learn something.

Andy Crowder
Editor and Chief Options Strategist
Options Advantage
Wyatt Investment Research

Trading options is an investment strategy that has worked for Andy for more than 15 years. Now Andy is making options work for subscribers to hisWyatt Investment Research newsletter, Options Advantage. Since its inception in late September, Andy has earned an average 16% yield for hisOptions Advantage subscribers with an 88% win rate. Mind you, that was during a time when the market vacillated between the extreme high of the best October for the S&P 500 in 20 years and the extreme low following the worst Thanksgiving week for stocks since 1932.

— Andy Crowder - Options Advantage

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