Hey everyone.
This is Kirk again, here at Option Alpha.
And in this video, I want to show you guys how to pin your probability of success.
And before we even get into looking at one of the trades that we’re actually currently
in with GLD which is a gold ETF, I just wanted to let you know that making high probability
trades and determining the amount of wins that you want to have over the course of many,
many trades is really a subjective thing, it's really up to you.
And I’ll show you here in this video that you can practically pinpoint any chance of
success or any probability of success you want.
We can make trades if we chose to have a 90% or a 95% chance of success and we can also
choose trades that have a 60% or a 70% chance of success.
Now, there’s no right or wrong answer, it’s just a means of determining how conservative
or aggressive you want to be with your capital.
We tend to stay around a 15% to 20% probability of being in the money which I’ll show you
here in a second, and that means that we generally have about a 75% to 80% chance of success
when it comes to most of the trades that we enter on Option Alpha.
You can be more aggressive and come in a little bit closer or you can be more conservative
and go out even further.
You just have to know that it's all up to you how you want to pin your probability of
success.
With this trade that I have on the screen, this is a trade that we’re currently making
in GLD.
And the stock right now is trading at about 116, so it’s about 115.80.
It was about up almost $1.75 today.
It had a nice little move higher.
Now, when we entered this credit spread above the market, we knew going into this trade
that we wanted to have about a 75% chance of success.
Now, I’ll show you two different ways in this video that you can figure out how to
pin your probability of success.
The first is in Thinkorswim and it’s this column called “Prob.
ITM.”
And you can see it right here and we have it on both sides, both on the calls and the
puts, this probability of ITM.
And that probability means this is the likelihood of GLD closing above or in the money on the
call side of our strike price.
Visually, we can now see with hard numbers that based on the entire trading history of
GLD and gold, everything it’s ever done, every move it's ever made, the likelihood
that it becomes an in the money strike by expiration which is February, so we’ve got
about 46 days to go.
The likelihood that gold trades from where it is now at 116 all the way up to and above
our strike at 121 is only about a 24% chance of happening.
What that means is that we’ve got almost a 75% chance that that doesn't happen.
If there’s a 100% chance that gold trades between zero and infinity and a 24% chance
that it trades above 121, then there’s a 75% chance that it trades below that price
point.
In this case, the trade that we entered, this credit spread where we did the 121/124 call
credit spread has about a 75% chance of being profitable.
That’s just like where we want to be with some of our trades.
We could’ve been a little bit more aggressive or conservative with this trade.
It really doesn't matter, but that's exactly where we actually entered this trade.
Now, if you wanted to be a little bit more conservative and let’s say you wanted to
have a probability of success around 90%, then you would actually go further out of
the money and sell options say up at the 126 strike.
By selling options up at the 126 strike, you’re then able to have a probability of that strike
being ITM or in the money of 10%, meaning you’ve got about a 90% chance that GLD never
closes and trades above 126.
And obviously that makes sense.
We went further away from the stock, so there’s a less likelihood that the stock rallies even
higher than 121 where our strikes are, but what you’re giving up by increasing your
probability of success is that the options are worth a lot less up here.
Your potential profit is going to be a little bit less because the market is incredibly
efficient, so as you increase your potential chance of success, the amount of money that
you make, your total dollar value actually goes down.
Now, you can visually see here on the chart that you can pinpoint your probability of
success anywhere you want just by using probability of being ITM inside of the Thinkorswim platform.
Now, a big question that I always get is, “Kirk, what if I don't have this probability
of being in the money?
What if I use some other broker like Fidelity or Trade Station or Trade Monster?”
Well in that case, what we can do is we can use Delta as a very rough estimate for probability
of being in the money.
And you can see here right next to each other that these options have about an equivalent
Delta as they have probability of being in the money.
Now, I say it’s got to be a rough estimate because it’s not going to be exact, but
it’ll give you a good framework of what option strikes you want to choose.
In this case, the 121 calls that were currently short have an exact probability of being in
the money of 24%.
That is 100% more accurate than anything else that you could use.
But Delta right now is at .26, so you could basically say the .26 is equivalent to about
a 26% chance of being in the money.
Likewise with our strikes that were a little bit further out, the 126 calls, you can see
that those had about a 10.1% chance of being in the money.
And the Delta on those is .11, so not 100% accurate, it's not always going to be the
same, but it does give you a good road marker to use as you’re trying to look for strike
prices and pin that probability of success.
Hopefully this video has been very helpful for you.
As always, if you have any comments or questions, please add them right below this video tutorial.
And happy trading!