Liquid markets allow us to execute trade ideas. Selling options when implied volatility is high increases our chances of success. Trading small lends itself to trading often, keeping us from becoming overly concentrated in one position. In the fourth episode of “10 Reasons to be a tastytrader,” Dylan, Tom, Frank, Mike Butler and Ryan discuss the role of probability in trading.
Traditional finance is filled with “experts” predicting price direction. All of these predictions are predicated on an opinion. Opinions are subjective and what formulates an opinion is anyone’s guess. Numbers, on the other hand, are objective and their motives never need to be questioned.
Volatility allows us to calculate the expected move or range within an asset will trade. In fact, we can accurately calculate that range 68% of the time. That range lets us know if the price of an option, much like the price of a movie ticket, is worth it.
As an example, Facebook (FB) will report earnings today, after the close. With an implied volatility in the weekly options of about 71%, we know that 68% of the time, FB will move up or down around $6 in the next day. FB is currently trading around $128 which means it can be expected to trade in a range of around $122 - $134. Which direction FB will move after their earnings announcement is anyone’s guess.
As Ryan pointed out, probabilities can be used as a gauge. Knowing the expected range in which an asset will trade allows us to structure trades with high probabilities of profitability. If FB has a 68% chance of trading between $122 and $134 we can gauge where to sell options and collect premium.
When we sell options, our maximum profit potential is limited to how much premium we collected. However, we are willing to accept that profit ceiling in exchange for knowing we have a statistically high chance of being profitable. Selling options, like both Ryan and Mike Butler said, is how insurance companies and casinos operate.
There is a reason casinos and insurance companies are profitable. They are both willing to accept limited profits spread out amongst a number of high probability occurrences. Yes, there will be times someone hits that million dollar jackpot or catastrophe strikes and insurance companies have to make large payouts. However, those payouts are infrequent. Over time, money brought in from losing gamblers and premiums paid on policies that are never paid out on can bring in substantial profits.
Dylan’s verdict was clear. Companies can lie. Analysts can have price targets based on agendas. We can convince ourselves we are right on a trade for a number of reasons. Opinions, in other words, are unreliable. Stick to the numbers because they have no opinion.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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