Most investors don't understand the true concept of leverage. In fact, the average guy trading from home takes on far greater risks than he probably realizes. Yes, the rewards can be amplified, but so can the risks.
Today, I'm going to show you how professional traders maximize their gains. I was lucky enough to learn these lessons from my mentor - a guy name Larry who was one of the first "floor traders" at the Chicago Board Options Exchange (CBOE).
Larry taught me to understand the importance of thinking in probabilities and how it allows me to define my own risk.
As a result, I can understand the risk associated with each and every investment in my portfolio. Plus, I'm able to follow a few simple guidelines that have allowed me to conservatively grow my wealth using options.
Here are a 5 ground rules that you must follow:
· Always think in probabilities (see it live by clicking here)
· 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
Do you think about probabilities on each and every investment you make?
Every successful trader that I've ever met is 100% focused on probabilities. And you should focus on this too.
Keep it Simple: Understanding Probabilities of Success
My favorite way to trade starts with this foundation:
Find a highly-liquid ETF in an extreme overbought/oversold state. That's when I begin to look for a high-probability trade.
But before I get into the heavy stuff, let me start out with some obligatory technical mumbo jumbo and then I will get to an example that should hopefully help to clear things up.
Probability of expiring out-of-the-money: The “probability of expiring” reflects whether the price of the underlying stock or ETF is above or below a strike price at expiration.
A stock or ETF will either finish out of the money or in the money, so there are two possible scenarios for probability of expiring: probability of expiring in the money or probability of expiring out of the money (Prob.OTM).
We want to keep it simple, so let’s focus on what matters – probability of expiring out-of-the-money.
Probability of expiring out of the money is the chance that a strike price will close at expiration below an underlying stock price for calls and above an underlying stock price for puts.
My preferred trading software – Thinkorswim from TD Ameritrade – offers this helpful tool. For those of you who do not have a platform that offers Prob.ITM, you can just use the delta of an option, as it is roughly the same percentage.
I will explain in a moment why it is so valuable to know the Prob.OTM. Again, before I get to the nitty-gritty, let me explain “probability of touching” (Prob.Touch).
Probability of touching considers the possibility of the stock hitting (touching) the strike price at any time between now and expiration.
Again, I realize that you may not have access to trading software that gives you the probability of touching. Any worthy trading software will provide you with the delta of an option. And the Prob.Touch is simply double the delta.
So, the real question is, how can we use Prob.OTM and Prob.Touch to our advantage? Look at the chart below.
When I was putting together this example, the price of the SPDR S&P 500 ETF (NYSE: SPY) was trading at $250.09 and in an overbought state. My assumption based on the current overbought state of SPY is that the S&P 500 would move lower or at least slow down its current upswing over the next 30 days.
This is where it gets interesting.
Because I think SPY will slow down its current ascent, I want to choose a strike that had a Prob.OTM that is at least above 50%, and in almost all cases higher. I prefer 80%.
Look at the strikes below for SPY call options to see what qualifies – 208 and above. The strike immediately above the price $250.09 of SPY, 251, has a Prob.OTM of 56.84%.
That’s not high enough for me. It is essentially a coin flip. Again, I prefer something that has a higher Prob.OTM – say the November 255 strike, for instance. It has a Prob.OTM of 76.66%.
That means that that if I sell a vertical call spread, otherwise known as a bear call spread, I might sell the 256 call strike and buy perhaps the 258 strike. The trade would have a probability of success (also known as the Prob.OTM) of 81.49%. Extrapolate the 81.49% out 100 trades or 1,000 trades and you begin to see the value of using options strategies with a high Prob.OTM.
But what about Prob.Touch? How does that factor into all of this probability madness? Prob. Touch should be viewed as the potential stress level of a particular trade.
In our case, if we sold the SPY November 256/258 call spread, the underlying ETF would have a 38.52% chance of touching our short strike of 256. I like that percentage because there is still a low probability that SPY will “touch” my short strike.
You'll find that this is invaluable information, because it gives you a good idea of how stressful the trade will be.
Just think if we decided to choose to short a strike with a lower Prob.OTM, which inherently has a higher Prob.Touch – at say, the 254. Again, we want to use a bear call spread, so we would sell the 254/256. The 254 has a Prob.OTM, or probability of success, of over 71%, which is still fairly high, considering a stock trade only has a 50% chance of success.
But if you notice the Prob.Touch you will discover that the probability is over 58%. That just means that while you still have a good chance of the trade going in your favor, you should expect to experience some stress with the trade.
Most traders don’t think about this important aspect. Always remember – you want to take emotions out of the equation. One way to do this is position sizing, which should ALWAYS be considered with each and every trade. But the other way is to keep your Prob.Touch below 50%, and preferably below 30%.
These strategies are NEW for most folks. And that's why I'm organizing a 100% FREE training for Strike Price readers.
Training #1 starts on Tuesday. Go here right now to access my LIVE trading event:
The #1 Rule for Earning $1,393 in Monthly Options Income