When speaking of investing, absolutely nothing is more important than discipline and careful risk management.
This fact is particularly true when investing using options, because options offer an enormous array of strategies coupled with a huge amount of potential leverage. Essentially, an investor can purchase the right to a large portfolio with a comparatively small capital outlay.
The typical investor doesn’t understand the true concept of leverage. In fact, the average self-directed investor takes on far greater risks than they probably realize. Yes, the rewards can be amplified, but so can the risks.
But we aren’t the average investor.
We understand the importance of thinking in probabilities and how it allows us to define our own risk. We understand the risk associated with each and every investment in our portfolio. Lastly, we follow a few simple guidelines to lay the groundwork necessary to prudently build wealth using options. Here are a few ground rules to follow:
· Always think in probabilities
· View options as an investment, not a trade
· View options from a portfolio perspective
· Allow time to work for you
· Understand how options impact your overall portfolio
Over the next few weeks, I will discuss these guidelines in greater detail so that you can effectively learn how to use options to prudently build wealth.
Always think in probabilities
Do you think about probabilities on each and every investment you make? You should.
Why can’t a financial analyst simply tell me the likelihood that a stock will meet their expected price targets among the many pages of their detailed research reports?
Instead, the actual “pros” in the stock picking business give you a buy target without providing the probability that the target will actually get hit. That’s amazing to me.
The analysis coming out of Wall Street’s best has nothing to do with the actual likelihood of success! Wall Street analysts are little better than Vegas bookies.
Think about it – a stock goes either up or down, so your probability of success is always 50% … it’s essentially a coin toss.
I’m simply not interested in analyst estimates. And if you want to make money in the markets, I think you’d be best advised to ignore them. That’s because a price target is just a guess, in my opinion. And I’m not interested in guesses.
I want to hear the that the statistical chance of the stock going to $19.00 is X%, the chance of the stock going to $19.00 in three months is Y% or a stock moving lower over the course of the next year is Z%.
Confused? Let me explain because after I do, you will never look at an analyst’s price target the same.
Probability of a Stock Touching a Specific Price
Facebook (NASDAQ:FB) is currently trading at $28.77.
And yet, six of the most well-respected Wall Street analysts have a median target of $42 for the stock, with a high target of $48.
So how realistic are the professional analysts’ price targets? Let me show you what the market actually expects.
Options nerd alert: How do I get these probabilities? It’s easy. I take the delta of a certain strike
price and cut it in half. Most savvy options brokers offer accurate “probability of touching” data as part of their software package.
Basically the “probability of touching” estimates the likelihood of the market reaching the strike price of an option prior to the expiration date.
These numbers are displayed below over various timeframes: June, July, December and January 2014.
As you can see below, the probability of Facebook touching $42 in the next 15 days is 2.03%.
In the next 15 days the probability of FB touching $42 is 2.03%.
In the next 50 days the probability of FB touching $42 is 3.46%.
In the next 204 days the probability of FB touching $42 is 25.60%
As for FB touching the high target of $48 – well, even over the next 596 days (January 2014 LEAP expiration date) the probability of touching is only 30%.
So as you can see, the probability of Facebook successfully reaching $42 over the course of the next year or so is not very high … at least
according to current option prices. Yet most professional Wall Street analysts are predicting such a move with little regard for the statistics.
Why would you ever buy a stock based on an analyst’s price target that has a chance of success of only 2%, 3% or even 30%? It’s pure insanity. Yet this is how the majority of investors allocate their money – blindly listening to Wall Street predictions that make little, if any, sense. Remember, just buying a stock gives you only a 50% chance of success …. a coin toss.
The reason why I focus on probabilities of success so much is because it is truly what investing is about. It is the edge that gives self-directed investors the ability to achieve far better results than their professional counterparts. It gives self-directed investors the ability to build wealth consistently over the long term in a more consistent, defined way.
One day I would love to hear an analyst on CNBC actually state that the reason they are predicting a stock to move to a certain price is that it has a probability of success that is actually greater than 50%.
How do I make my trades based on probabilities? Well, I only consider a trade if it gives me a real statistical advantage. You should too.
The Trade Arena
Tuesday marked the historic release of Facebook options. Facebook opened Tuesday with record-setting volume as small investors and professionals alike pushed activity to more than 312,000 contracts.
The day also marked one of the best opportunities for options traders.
Because Facebook fits the following criteria:
The options are highly-liquid (tight bid/ask spread)
·The stock is volatile
·The implied volatility is high
Basically, whenever you can find a highly-liquid options market in a $30 stock with a high implied volatility (inflated options prices) you have the ultimate trading vehicle. These types of scenarios don’t last long as a reversion back to the mean typically occurs. But, in the case of Facebook, the stock is in its infancy so the market hasn’t figured out what the expected move or true implied volatility is in the social media giant. Until the market can figure that out those details we should see inflated options premium which means wonderful opportunities for selling options in Facebook
using credit spreads.
— Andy Crowder - Options Advantage