7/26/2023 0 Comments Cancel protrader subscriptionTom Preston, Luckbox contributing editor, is the purveyor of all things probability-based and the poster boy forĪ standard normal deviate. The credit from the short put drops faster than the capital requirement and gives the higher probability trades a lower potential return on capital.Īnd if the SPX crashes, all those short puts will lose money, and selling a put for a much smaller credit doesn’t necessarily reward a trader for taking risk.Ĭhoose high probability options trades, but balance probability with capital requirements and potential profit for the risk a trade presents. Moreover, while the capital requirement to short the 4510 put is about $74,000, the requirement for the short 4325 put is $56,000, and for the short 4100 put is $41,000. Further, the 4100 put had a 90% probability of profit at expiration and was worth $19.50.Īs the probability of profit increases, the potential profit from shorting one of those puts decreases significantly. The 4325 put in the same expiration had an 80% probability of profit at expiration and was worth $37. The higher the probability of making a profit, the lower that potential profit is.įor example, with the SPX index at $4,700, the 4510 put with 50 days to expiration had a 70% probability of profit at expiration and was worth $64.20. Probability and potential profit have an inverse relationship. After all, a high probability of profit is better than a low probability of profit.īut if a trade with a 70% probability of profit is good, isn’t a trade with an 80% probability of profit better? Not always. Quantifying the probability of making money is one of the most important parts of trading options. When that happens, the trader selling that option captures more reward for taking risk than if they took risk when volatility is lower.Įvery trade has risk, but shorting options when volatility is high means the reward for taking risk is magnitudes higher. With high volatility, the reward for taking risk becomes magnitudes higher. But more often than not, the market or a stock doesn’t move as much as the increased volatility predicts. When the market is nervous or uncertain about the future, volatility tends to go up. And when volatility is high, that advantage is increased by the elevated option prices. Options sellers have a statistical advantage over options buyers. Volatility doubled, but the put’s premium increased four times. But when volatility is high, options premiums can be much higher.įor example, a 95 put with 60 days to expiration on a $100 stock is theoretically worth $0.66 when its volatility is 15% but $2.64 when its volatility is 30%. Risk is present in any trade, even when market volatility is low. High volatility rewards traders for taking risk. Wall Street and traditional financial media try to teach people to fear volatility, but it can be one of an options trader’s most important tools. Trading liquid options lowers the edge a trader pays, which increases the overall chance of making money. Narrow bid/ask spreads and high trading volume and open interest mean a trader can work an order to buy or sell an option in between the bid/ask and have a good chance of getting filled. Liquidity is a measure of how efficiently a trader can execute trades and keep the edge to a minimum. That’s $1,000 shaved off your account that has nothing to do with the quality of your trade decisions 01 edge on each option would amount to giving the market $1,000. That doesn’t sound like much, but over the course of a year, a retail trader who’s engaged with the market might make more than 1,000 opening and closing options trades. The same is true for 100 shares of stock. So, an order to sell that put for $2.01 would keep that edge, that cost, to a minimum. The edge to a market maker is a cost to the retail trader. The bid/ask spread in a stock or option is a measure of the “edge,” or advantage, that a market maker has when a customer buys something at the ask price or sells something at the bid price. In 30 years of working as a floor trader, hedge fund manager, and now retail trader, I learned that the tick is the trade. So, why not just hit the $2.00 bid and get in the trade? Fighting for a $.01 advantage could cost profits. If the stock rallies, the put’s price might drop from $2.00, to $1.50, to $.75 and lower.
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