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Option R:R vs. probabilities


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Option R:R vs. probabilities

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  #1 (permalink)
 lrfsdad 
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When trading options, what is a good ratio of probability vs reward:risk? When buying naked options, the risk is capped with exponential returns possible, but the probability is low.

Credit spreads: say you are collecting .50 in premium with a maximum risk of 1.50. but there is only a 15% chance of the market fully expiring past your purchased option. (100 trade sample: 85 trades gross .50 = 42.5, 15 losses x 1.5 = 22.5, 20 profit) Is this favorable? What would be?

If doing an Iron condor, would you keep strikes equal from the current underlying or extend one side of it based on probability?

Just looking for general discussion or guidelines that others use when putting on credit spreads. I've recently started tracking some Iron Condors in a sim acct and am looking for some input from others.

My research is showing that you should be able to calculate probability based on models using volume, greeks, volatility etc.

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from my limited understanding iron anything is going to limit your rate of return, two great option traders i have study one preferred butterflies and other strangles, they both actively manged the trade after it was on. but as always you are going to need to know your greeks and what conditions are needed to place the trade.

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 lrfsdad 
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jupiejupe View Post
from my limited understanding iron anything is going to limit your rate of return, two great option traders i have study one preferred butterflies and other strangles, they both actively manged the trade after it was on. but as always you are going to need to know your greeks and what conditions are needed to place the trade.

I too like strangles, and had success with them in higher volatility environments (in the es). Strangles in stocks seem more dangerous with out the out of the money protection like you have in an iron condor. You never know when a buyout, lawsuit etc will move a stock exponentially

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 lrfsdad 
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I put this trade on in LULU on Monday. I chose short strikes about 10% out of the money on the weeklies. Then the next strike for the long protection option.


It expired worthless on Friday.



Being in a downtrend, I am posting the probability of this expiring below the short strike with a calculator I found at Free Probability Calculator | Option Strategist I used the implied volatility of the short put for this example:


So I risked $1715 to make $685. distance between short option and long option - credit recieved.

There was a 18% chance that the underlying got below the short put (and even less that it got to the far out protective long put) Was this a good R:R?

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 addchild 
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lrfsdad View Post
Was this a good R:R?

$685(.818) - $1,715(.181) --> $560.30 - $310.415 = $249.885

looks good to me.


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 lrfsdad 
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lrfsdad View Post
So I risked $1715 to make $685. distance between short option and long option - credit recieved.

oops, I risked 1815 to make 685.

685/1815=37% ROI in 5 days.

so using the above mentioned probabilities of about 20%, if I do this trade 100 times, 80 times I would make 685, or 54800 total and I would lose $1815 20 times or $36300. Leaving a net profit of approximately $18500. IB includes commission in their p&l calculations, but trading ten lots at a buck a piece would be $20 per rt or $2000 on 100 trades so the 18500 is 16500.

assuming I can trade weeklies, It would take two years to fulfill this example. If you calculate roi based on the maximum risk taken each round turn(i'm not sure what was charged for margin) 16500/1715=962% in two years.

If the first 20 trades went bad, that would be a cost of $34300. then your roi would be 16500/34300 = 48% in two years.

Still I'm wondering if this is valid statistically and if my calculations are correct?

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 lrfsdad 
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I should mention that I came across this stock using a high implied volatility over historical stock scan at IB. I would post a screen shot, but implied vol isn't coming up probably because the mkt is closed.

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 lrfsdad 
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using the same criteria, I have the same spread on in GES. April expiry though so a few weeks left. Put on when the stock was 27.92 on 3-12-13. It closed Friday just over 25.00. Implied vol vs historical was 49.4 vs 27.7. my position is:
Long April 23P
Short April 25P
Short April 30C
Long April 32C

My short put is ATM. Spread is slightly in my favor:
here is shot of the option chains when I put the trade on and after Friday's close:

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 lrfsdad 
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One of the motivating factors for this thread was this video OPTION TRADER makes $105MM PROFIT in the NDX, SPX & RUT - Her STORY Uncovered - YouTube
I watch this channel on my roku during the trading day when possible. These are the guys that created thinkorswim. Also thanks to @ron99 for his futures options thread.

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 lrfsdad 
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even with the short put at the money, the spread is slightly ahead (about $180) I've decided to hold as opposed to cover as there is alot of premium left on the short 25 put and with just over 2 weeks, time decay is on my side.

Note the vol crush after the earnings announcement:




GMCR has had rising vol going into earnings. I may have made a mistake as earnings are after this expiration cycle so volatility may continue to rise which will hurt the spread. Regardless It appears there is less than a 20% chance of either long option getting hit, so I am playing that as opposed to an earnings direction:




Is anyone else out there playing a similar game and have any advice on what I'm trying to do?

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 Bermudan Option 
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I am working out a few things on the SIM as well, but my positions are mostly two legged positions. I have to do a bit more research on Condors...

What are the strike prices for your GMCR trade?

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 lrfsdad 
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Bermudan Option View Post
I am working out a few things on the SIM as well, but my positions are mostly two legged positions. I have to do a bit more research on Condors...

What are the strike prices for your GMCR trade?

Long 65 call
Short 62.5 call

stock at time of putting on position: 57.40

short 52.5 put
long 50.00 put

Here is a better shot of the positions with the contract description column widened:


Today was a blood bath in the underlying, didn't see any news, position against me $292.00

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 lrfsdad 
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the GES and GMCR positions expired worthless about 10 minutes ago. Will show p&l after settlement on my statement over the weekend:

So far 3 postions, 3 winners. no emotion, just probabilities.

New position today:



This position will be a good test. Appears to be in a minor downtrend, but approaching previous resistance, meaning possible new support. regardless, probabilities are approx 25% or less that one of my short strikes is in the money at expiration. Earnings next week might put me at a small loss, but that is the name of the game.

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 lrfsdad 
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Will show p&l after settlement on my statement over the weekend:



1158.80 profit on both spreads 3341.2 Risk. 34.6% ROI

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 lrfsdad 
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Akam beat expectations by .04 and this means a 20% rise in the stock today: I have been using a tgt about 10% away from current prices (short strike) for the purpose of this exercise.



I wanted to have one or two positions go full against me like this in my practice acct before I start this in a live acct. "felt" good enough about it that I put on a very similar spread in my IRA, oops

It's easy to react to a situation like this by trying to play a reversal. Although if wrong, I'm adding to the total loss. I will sit tight for the time being as i've seen these reactions wear out after a few days. Time will tell

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 bryanzim 
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I was wondering whether you are actively trading these strategies still and what kind of success you are having?

I myself have been trading weekly credit spreads in futures(ZN, EUR, & ES) when they are next to support or resistance. I have also performed credit spreads in the indices(RUT), but I am interested in expanding into some of the weekly stock options.

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 lrfsdad 
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bryanzim View Post
I was wondering whether you are actively trading these strategies still and what kind of success you are having?

I myself have been trading weekly credit spreads in futures(ZN, EUR, & ES) when they are next to support or resistance. I have also performed credit spreads in the indices(RUT), but I am interested in expanding into some of the weekly stock options.

I've found that the event causing the high volatility (like earnings) throws probabilities out the window. Since I started this thread, my business has been occupying more of my time. IB doesn't appear to allow market scans after hours, so I'm unable to work this strategy at this time.

So far it seems that if you can trade an option with high vol, but expires before the event, that is the best way to go. Usually this would be in stocks that have weekly options.

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Greg Loehr
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As to the original question, there's no such thing as a "good" risk vs reward in that there's no edge in option pricing. If/when 'edge' appears, the computers at Goldman Sachs pick it up and it gets traded out of existence.


And probabilities are only useful if combined with a time frame - which is usually expiration. So unless you intend to carry your trade to expiration, with no trade management, probability doesn't mean anything.

Choose a risk/reward that you're comfortable having, and then manage the trade from there.

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Strato
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lrfsdad View Post
I've found that the event causing the high volatility (like earnings) throws probabilities out the window. Since I started this thread, my business has been occupying more of my time. IB doesn't appear to allow market scans after hours, so I'm unable to work this strategy at this time.

So far it seems that if you can trade an option with high vol, but expires before the event, that is the best way to go. Usually this would be in stocks that have weekly options.

What does IB's market scan allow you to do? I have been researching free web-based market scanning tools and some of them might do a decent job but I'm still definitely a newb.

So this one is kind of rudimentary:
Free Stock Screener ? MarketWatch

This one at Google is worse actually:
https://www.google.com/finance/stockscreener

This one from Yahoo seems the best so far. It is the only one that lets you search on some form of volatility:
Stock Screener - Yahoo! Finance

WSJ.com seems to have a somewhat sophisticate one. One thing I'm looking for is to find a screener with moving average crossovers. This only lets you screen stocks that are over or underperforming various moving averages.
Stock Screener - WSJ.com

StockFetcher.com seemed to have a pretty full capability. Not free though--$8.95 a month.

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Greg Loehr
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lrfsdad View Post
I put this trade on in LULU on Monday. I chose short strikes about 10% out of the money on the weeklies. Then the next strike for the long protection option.


It expired worthless on Friday.



Being in a downtrend, I am posting the probability of this expiring below the short strike with a calculator I found at Free Probability Calculator | Option Strategist I used the implied volatility of the short put for this example:

Why not just use the delta of the option to calculate the probability of expiring in/out of the money?

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 lrfsdad 
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Greg Loehr View Post
Why not just use the delta of the option to calculate the probability of expiring in/out of the money?

I'm not familiar with that strategy, please advise. Thanks!

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  #23 (permalink)
Greg Loehr
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It's not a strategy. If you're interested in the probability of an option expiring in/out of the money, you can just look at the delta. It's a decent approximation of an option's probability of finishing in the money. Much easier than going through some option calculator.

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Greg Loehr
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But...also remember that whenever you attach a probability to something, you also have to attach a time frame. So using the delta as a surrogate for probability assumes expiration as the time frame.

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 lrfsdad 
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so your saying an option with a delta of .2 has a 20% chance of expiring ITM? This is figured into the pricing weather it expires in a week or 6 months? Obviously as the delta increases, so does the chance of being ITM.

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Greg Loehr
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Yes, it's figured into every option, and every expiration. But keep in mind a few things. First, it's an approximation. It's pretty close, but still an approximation. Second, it's constantly changing due to volatility changes, movement in the underlying, and the passage of time. Third, it doesn't say anything about "profitability".

There's nothing magical about calculating the probability of something finishing ITM. It's the time that the market goes against you and how you manage the trade that really counts.

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termn8er
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Another great post by Greg! Saying it a different way, probability assumes you stay in the trade until expiration. Most traders never do this. Also you can double that probability and approximate the chance of getting hit by price. At this point most short traders have adjusted their trade. So the way I look at it is the higher the probability of a short, the more likely I won't have to adjust before I exit. But it also means I have less credit do deal with adverse moves.

Finally most option trades like High Prob condors means you get low credit in exchange for the high probability. So to get returns, you need to stay in the trade as long as possible to have the decay. In lower prob trades where you get a much better reward to risk, you can just take a piece of the decay and exit. So your market exposure is much less with a lower prob trade.

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Greg Loehr
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Thanks.

If you're going to sell an iron condor, sell the options with a 16 delta. That puts your short strikes approximately at the end of the expected range on both sides, and now at least you're taking volatility/expected range into account rather than a raw probability or R:R.

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 lrfsdad 
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@Greg Loehr

I just read your article in this month's issue of futures magazine. Can you provide some candidates for this strategy?

Thanks

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  #30 (permalink)
Greg Loehr
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Take a look at YHOO for example. We're watching this closely and this strategy is up 5.9% in first month.

CLF is another.

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 lrfsdad 
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Do you want to have a directional bias when employing this strategy?

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