When Trading Options Uses Probabilities To Your Advantage

Includes: SPY
by: Andrew Crowder

I am often amazed by the lack of common sense when it comes to investing.

Investors seek the best possible information, but unfortunately most turn to the wrong sources.

For starters, turning on the television for investment advice, in most cases, is a big no no. Yet, how many people listen intently to the daily drivel coming out of screaming mouths on CNBC. Investors, particularly traders, should know that every trade spouted from these sources have a 50% chance of success. Add in transaction costs and the probability declines further. Yet, the majority of investors and traders take this approach, mostly because they are not privy to any other form of investing. Self-directed investors are not aware that there are strategies based purely on probabilities, not gut-driven analysis.

For instance, take a look at the year-end targets for Goldman Sachs. Chief Equity Strategist David Kostin has been adamant about Goldman's price target of $1250 for the S&P 500 by year end. What does the option market say about the probability of his stance:

If you look at the quarterly put options for December expiration cycle you can see that there is only a 9.6% probability of SPY hitting $125 or roughly 1250 on the S&P 500. Moreover, there is only a 4.9% chance that SPY moves to that level and stays there by the end of expiration. Those are not good odds. Why would anyone make a directional play with a 5-10% chance of success? It doesn't make sense. And why would Goldman come out with such an outlandish call?

I wish they would say something like, I think the S&P 500 is going to 1250 by the end of 2012, but there is only a 5-10% chance that it will happen. You would never hear that stated publicly and I think we all know the reason why.

You see, I don't really care about the opinions of others when it comes to the market. You shouldn't either. Next time you hear a talking head say that Apple is going to $1000 or down to $250 take a look at the options market. You will be surprised what the probability is on each and every guess.

Fortunately, as an options trader I can use these same probabilities to my advantage. Rather than buy a call or put with less than a 50% chance of success, I can sell out-of-the-money credit spreads with a high probability of success, typically over 80%. This puts the odds in my favor. Just think if you went to a casino and they had a game on the floor with an 80%+ chance of success. Well, that is exactly what is happening in the options market, but for some reason self-directed investors aren't interested. Most people complain about the risk/reward of an out-of-the-money credit spread, but those are typically the ones that haven't traded this way for a period of time. They don't understand statistics, but for some reason they understand the voodoo logic spouted by the major financial media outlets.

Again, I am only scraping the surface on this topic, but I plan on delving more deeply into this discussion.

As for the current state of the market, two out of the four major market benchmarks are still in a short-term overbought state. Typically, when I see a situation like this I will begin to sell out-of-the-money bear call spreads. This gives me a nice margin for error, roughly 5%, but it depends on what the implied volatility is at the time. The higher the IV the larger my margin for error.

In my opinion, this is the only way to trade. Use the probabilities that the market provides you.

Disclosure: I am short SPY, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.