Hey everyone.
This is Kirk, here again at optionalpha.com.
In this video, I want to help define a little bit more this concept of high probability
trading and how we can really find trades that are high probability.
I’m sure you’ve heard us say it before, but it’s worth saying over and over again.
Unlike stocks which theoretically have a 50/50 chance of going either direction at any one
point in the future, with options trading, you can basically pinpoint the probability
of success that you would like to have on a particular trade.
We favor option selling as a general strategy, so what we like to do is sell options that
are far out of the money and give ourselves an opportunity to make a small credit should
the stock not go that far out of the money and basically stay range bound wherever we
decide to choose our strike prices.
In today's video, we’re actually going to look at XLE and just going to use an index
ETF as a good measure because it doesn’t have earnings and it’s highly liquid.
You can see today as I'm doing this video towards the close of the day, it’s got about
28 million shares that were traded today and the options on the underlying stock have pretty
good liquidity as well, so lots of contracts to choose from, have strikes, dollar wide
strikes, there’s a lot of activity in the market.
One of the things that we like to do is we like to trade at about the one standard deviation
level.
We’ll explain more about that later on as we get through this course and these modules.
But basically, what that means is we like to have on any one side of our trade about
an 85% chance of success.
Sometimes that means that we come a little bit closer to the market and we trade with
a 70% chance of success, sometimes we go a little bit further away and maybe trade with
a 90% or 95% chance of success, but we like to target most of our trades around an 85%
win rate.
That means if we make 100 trades, we should win 85 of those times if we make 100 trades.
Here’s how we bring definition around that.
With XLE, the stock is currently trading at about 73.5 and it's live market right now,
so it’s moving around, but it’s 73.39 right now.
What we want to do is we want to go out to February in this instance and you can see
the February options have about 38 days to go, so this is our timeline of our trade,
just about 38 days and we want to make a trade that gives us a very high probability of success.
And just quickly before we look at that trade, it's important to know here that this trade
in and of itself may or may not be a winner, but it’s making this same type of trade
over and over and over again, the same type of high probability trade that leads to a
long-term consistency in your account and a lot of winners.
With the February options about 38 days to go, we are going to go down to about the 64
strike price level and you can see we already have a working order in here for this spread.
A 64 strike basically means that we’re going to go down below the market.
Remember, XLE is trading at 73.5 and we’re going to trade and make our strike price down
here at 64, so almost $9 below where the market is currently trading.
In this case, what we’re going to do is we’re going to sell a credit put spread
and I just want to go through that action of just selling that put spread real quick,
so you can see what that looks like.
In this case, we sell the 64/63 credit put spread.
Don’t get too confused on this.
We’ve got tutorials and modules about how to do credit spreads, but just go with me
on the logic here as we go through this part of the course.
I just want to open up this order dialogue box here.
With this spread, you can see that we can at most make $16 which is the difference between
buying the 63 and selling the 64.
The difference between those prices is $16.
Because it's a $1 widespread, we can actually lose about $84.
In this case, we have a loss that could be much higher than what we actually sold the
spread for.
But that's not the point here.
The point here is that we have a very high probability of success on this trade and as
I’ve said many, many, many times, if you are willing to cap your win at $16 or some
small amount and increase your risk, you have a much higher chance of success long-term
trading the markets than you do doing anything else.
In this case, we’re risking $84 to make $16 and what’s really cool about this trade
is that we have a super high probability of success.
When we look inside of our platform here on Thinkorswim, we have this column that says
“probability of being ITM” or in the money.
What this probability means is that this is the likelihood that XLE goes from where it’s
at right now at 73.5 and trades all the way down to and below 64 between now and February
expiration which is 38 days.
This probability is only 16.5%.
What that means is that we’re trading with about 84% chance of success on this trade
because there’s only a 16% chance.
Right here, we can visually see it.
We know exactly what it is.
Based on the entire trading history of XLE, there’s only a 16% chance that the stock
in the next 38 days goes from where it’s at right now at 73.44 and closes all the way
below 64.
That adds a lot of definition to how we make high probability trades and why it's actually
so easy to make high probability trades, you just have to know where to look.
In this case, we can actually be more conservative or less conservative if we want.
As you can see on the chart here and I’ll just drop that, we actually have probabilities
that range from 50 which is right at the money, 50% probability, all the way to basically
a 95% chance of success.
If you wanted to say let's take a 30% probability level which would be the 68.5 strike puts,
then what this means is that you would have about a 70% chance of success, so a 30% chance
that the stock closes below this level and about a 70% chance that the stock closes anywhere
above that level.
You can see right now, we can pinpoint our exact probability of success wherever we want
when it comes to trading options.
We'll talk more about these different strategies and how to select the strike prices, but this
has hopefully been really helpful in just adding some definition and context to this
idea of high probability trading.
As we go to the chart here of XLE, (and let me just make this the base chart here and
we'll just take away most of the stuff) what you can see here on XLE is that it's trading
at a really low level already, so 73.46.
Remember, our strike was all the way down here at 64.
This means that we have distance between ourselves in the market, XLE can drop all the way down
to 65, it can drop all the way down to 64 and we still make money on this trade.
We basically want XLE trading anywhere 64 and above and that is the perfect definition
of a high probability trade.
We’re not making a big directional bet on the stock, the stock can go sideways, up or
down and we still make money on this trade and that's why options trading is so powerful.
As always, if you have any comments or questions about high probability trading or this video,
go ahead and add them right below in the lesson page.
I’ll make sure I get all of the answers to you guys in a timely manner.
Happy trading!