I’m going to go out on a limb and publicly declare that this podcast will be one of our top 3 to 5 shows we ever recorded. Aggressive and overly confident, maybe – but I have absolutely no doubt this podcast episode will be a game-changer for hundreds of thousands of options traders. The expected probability paradox for options traders, as I have coined this problem, is one of the most understood aspects of option selling and premium strategies. The root of this problem starts with the misunderstanding of initial strike price probabilities, perfect pricing of option spreads, and the impact of implied volatility on when rates and drawdowns. On today’s show, we are going to dive deep into the three main areas of the expected probability paradox to help you understand why option selling, even in its purest form, even if you cannot find perfect pricing, still outperforms the market. We’ll also talk about why laddering in some additional active management strategies such as profit-taking and making adjustments or rolling trades helps stabilize portfolios and increase returns. Put simply, skip this show at your own risk.
Key Points from Today’s Show:
- Perfect pricing in any market environment is always the goal you’re reaching for.
- In reality, perfect pricing is not found that often especially when markets have really low IV.
- Traders end up not making trades because they think they have to hit this magical target.
- If the market were to play out exactly like the initial probabilities suggest, you might have to get the perfect pricing in order to make money.
- Traders often have a fear of the few losing trades being so big that they outweigh all of the small winning trades.
- However, in reality, this is not the case.
The Expected Probability Paradox
- A lot can happen between when you enter a trade and expiration.
- There is a big difference between probabilities on trade entry and the reality at expiration.
- There are intangibles that you don’t see in the pricing or the probabilities when you initially make a trade.
Three Key Elements
1. IV’s Over Expectation.
- IV is always expecting the stock to have a huge move one way or another.
- More often than not, the stock never makes those moves on a consistent basis.
- Of course, there will be times that the stock has huge moves.
2. Managing Winners/Profit Taking.
- Taking money off the table earlier can lead to increased profits, and decreased drawdowns.
- When to take the trades off is dependent on the market scenario.
3. Adjustments and Rolling.
- You do not need to be great at adjusting and rolling
- If you have the ability to adjust trades and reduce risk, and roll trades and extend duration, you will take your trading to a much higher level.
- With adjustments and rolling you start to fight the drawdowns, chipping away at the losing trading to reduce their impact on the portfolio or completely turn them around.
- When you roll trades you extend the timeline, giving yourself an extra 30 or 40 days to see if the trade works out.
Scenario 1: DIA Credit Spread
Back-tested a DIA put credit spread. Set it up to enter at least one trade every week, targeting 40 days to expiration, with no IV filter, allocating 30% of the portfolio to this trade with 70% sitting in cash. There was no profit exit and no stop-loss. Sold options with the short strike at the 30 Delta — 30% of losing on the trade, and 70% of winning. Set up all the put credit spreads to have a $10-wide strike.
- 193% return over the same testing period against the S&P 500
- The trade won 83% of the time.
- That 13% differential is the over-expectation found in IV.
- The same thing happens if you run the call-spread side.
- The average premium was $121.70, which is less than half of what traders think they should be taking in.
- Maximum draw-down was 52%.
Scenario 2: DIA Credit Spread
Back-tested the exact same strategy — a weekly put credit spread, 40 days to expiration, no IV rank, 30% of your portfolio, short strike at a 30 Delta, spread width of $10. The only change is that we added a profit target of 50%. Took money off the table whenever the portfolio reached a 50% profit target.
- Win rate was 89%.
- Maximum draw-down was 50%
- Generated a more stable portfolio than in Scenario 1.
Scenario 3: IWM Short Strangle
Back-tested an IWM short strangle. Kept the same weekly frequency, same 40 days to go until expiration, no minimum IV rank, same 30% portfolio allocation, no profit taking, no stop-loss. Only sold the short strike Delta’s of 20 on either side – 20% probability of being in the money on either side. The initial probability of success should be around 60%.
- This strategy returned 175% over the same testing period.
- It was 100% neutral, always selling premium on a never-ending basis, letting everything go to expiration, no profit taking, not stop-loss – should have won 60% of the time.
- This strategy out-performed the market even during the crash.
- Won at 78%, which is the IV over-expectation revealing itself in the form of higher win rates.
- Maximum draw-down was 45%, resulting in a much more stable portfolio.
Scenario 4: IWM Short Strangle
Back-tested IWM with the same setup — 40 days till expiration, no IV rank, no stop loss. The only difference was profit taking at 75%. Instead of letting it go all the way to expiration, hold until you get 75% of your potential profit.
- Saw a total return of 140%. By taking trades off a little bit early, we slightly sacrificed our total expected gain.
Did not make as many total overall dollars as in the other scenarios.
- However, we did smooth out our portfolio even more, due to increased consistency.
- Had better risk-adjusted returns by taking trades off early than by letting them go to expiration.
- Win rate was 81%, and drawdown was reduced to 41%.
- Average time in trade was 32 days.
Scenario 5: IWM Short Strangle
Ran the same trade at a 50% profit target level.
- Total return of 146%
- Saw a win rate of 88% and a maximum drawdown of 42%.
- Increased your drawdown by 1%, but in exchange, you increased your return by 6% and increased your win rate by almost 7% above taking profits at 75%.
- This really shows that there is no linear answer to this in many respects.
- Stayed in the trade for an average of 24 days.
- There is a relationship between taking money off the table early and increasing your win rate, reducing drawdowns and in many cases, increasing your potential return.
- This is not to say that this will always be the rule.
- There might be certain scenarios or setups where not taking money off the table is better.
- There is no “unicorn” strategy that works across the board; it is really dependent on the market scenario that you are in.
- If you want to take your trading to the next level and reduce your drawdowns even more, then you’ve got to get good at adjustments and understand how to roll positions.
Free Options Trading Courses:
- Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
- Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
- Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
- Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
- Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
- Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can’t seem to get answered, then this section will help you.
- Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.
- Trade Adjustments/Hedges [15 Videos]: In this popular module, we’ll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we’ll help you create an alert system to save time and make it more automatic.
- Professional Trading [14 Videos]: Honestly, this module isn’t just for professional traders; it’s for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.
Option Trader Q&A w/ Azim
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Azim, who asks:
When we sell the high probability or high IV options, the reason why the IV is high is because of the swings or possible swings in the stock price. So the premium we collect from those high IV options, would they always be enough to cover the possible swing in the stock value? There is a reason why the volatility his high in the first place; it is because the stock price is potentially going to go one way or the other. So you are counting on that and selling on this. I understand that the price for the IV is over-estimated, but would that always be enough to cover, even if you sell 100% IV rank?
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
PDF Guides & Checklists:
- The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
- Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
- Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
- Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
- When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
- 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.
Real-Money, LIVE Trading:
- EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
- VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
- DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
- COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
- TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
- MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
- IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
- TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
- XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
- COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
- EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
- IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
- SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.
Thank You for Listening!
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