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If you are tired of reading charts and if you find analyzing financial statements a complete bore, then perhaps there is another game for you trading the odds. This is a simple and clear-cut strategy for staying on the side of the "smart money".
In the options world trading the odds was once considered a professional's game; however, with the advent of computers and real-time data transmission, more and more retail traders have discovered the benefits of trading the odds. This approach is nothing new; after all, poker players have understood the odds for millennia. The next time you place a trade, ask yourself, "what are the odds of success on this trade?"
As you dip your toe into the waters of trading probabilities, it is easy to see the benefits of selling options. Numerous studies have shown the vast majority of options expire out-of-the-money. But for those who step a bit deeper into those murky waters and assume that it is always better to sell options than to buy, you are making a mistake. Options sellers win more often because they enjoy a higher probability of success. Option buyers, on the other hand, pay a premium for limiting their risk and therefore accept a lower chance of success.
Selling option premiums can be compared to selling insurance: it can be a lucrative business plan but you better have a good reinsurance plan when the hurricane hits. Because probabilities are so easy to grasp, traders often overlook the next blow-up that may occur in the real world.
For instance, it is very tempting to sell deep out-of-the-money calls and puts since the odds of success are so high. A short strangle involves selling an out-of-the-money call option and an out-of-the-money put option on the same underlying asset with the same expiration date. To manage risk, the options are written far out-of-the-money so that the chances of the market price breaching the call or put strike price, by expiration date, are greatly reduced. (See Chart Below)
Picking the strike price and duration for an option contract is a very simple decision when trading the odds. Since time is working with the trade, i.e., time decay is a welcomed ingredient, one is inclined to pick an expiration that is close to expiration. Next, a calculation or Greek term called 'delta' is applied to determine the probability of an option retiring in-the-money at expiration. A trader may simply pick a delta that is within his threshold of risk.
For instance, let's assume I wish to sell a short strangle that has a 90% chance or better of expiring worthless. I simply scan for a delta that is 10% or less on the call and 10% or less on the put. Recall that it is impossible for the stock to close above and below both thresholds on expiration, so one leg or one-half of the straddles is always a winning play.
In this example, there is a 5.7% chance that the call option will expire at or above the upper threshold and a 6.2% chance that the put option will expire at or below the lower threshold. Thus, there is an 88.10% (100% - 6.2% - 5.7%) chance that the stock price will close inside the boundaries. Are you comfortable with these odds?
A trader may also use the probabilities to adjust an existence trade. For instance, some option traders will close one leg of the short straddle if the delta or the probabilities improve to 40%.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our new Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.