What's in a Name?

10/02/2013 8:00 am EST

Focus: OPTIONS

Don’t be fooled by the terminology of high-probability vs. low-probability trade, note Seth Freudberg and Michael Schwartz of SMB Capital, as a profitable outcome depends on your adjustment plan and risk management.

Many who are new to options trading get excited when they hear about options trades that are “high probability”! What they think is that these option trades usually win and earn money. Thus a “low probability” trade must mean the chances of winning are lower. But is it really that simple? And why would anyone enter a low-probability trade if there is a high-probability trade available?

The answers to these options trading questions must be understood before you initiate your next options trade. In a previous article, we discussed what options probabilities are based on, namely, if you do absolutely nothing and hold the trade until expiration the probabilities should work themselves out. So is a high-probability options trade automatically deemed to be considered a good trade if we decide to do nothing? Let’s take a look at an example.

If we put on a typical iron condor trade, which is the combination of a short (bullish) put spread and a short (bearish) call spread at a short strike of 10 delta, we can first focus on the credit that we would receive. For example, if we look at the Russell 2000 as of June 24, 2013, an August iron condor would bring in a $1.65 credit with 10 point wide spreads. So is this a “good deal”?

Well, if each month we’d received the same credit and we win eight times out of ten (as the probabilities of this particular trade would suggest we will statistically) we would win 8 x $165 = $1,320. So what about the two losses that we are statistically likely to suffer?

We are risking $1000 – $165 = $835. If we lose the entire amount two out of ten times, our losses would equal ($1,670) and thus this “high-probability trade” would actually create a loss over a statistically significant period of time!

So if a high-probability options trade could lose money if not managed, what does that say about a “low probability iron condor”? The bottom line is, you have to look at this from a different perspective. If we compare the two strategies, the primary differences are the placement of the short strikes and the credit received.

For the low-probability condor, you are going to receive a lot more credit for the trade because the short strikes are much closer to at-the-money. This gives you more money to adjust your trade, whereas a high-probability condor in many instances requires additional capital to adjust the trade.

And speaking of adjusting, when you trade options, we rarely, just place a trade and walk away, holding until expiration. We almost always have a plan to either adjust or exit before we get hurt. This plan changes the meaning of the trade’s probabilities substantially.

One meaningful way of looking at the term “high probability” is to think of it from an adjustment perspective. Thus a high-probability trade has a higher probability that it won’t need adjusting vs. a low-probability trade. That is really the major difference.

As stated earlier, we have rules and plans on how to manage these trades and because of this you must not assume that a low-probability condor has a lower chance of making you money. As a matter of fact, many traders who start with trading high-probability condors end up preferring to trade low-probability condors because of the adjustment flexibility that they afford, due to the higher initial credit.

So don’t be fooled by the term “high probability” as chances are it is not reflecting the chance of you being profitable over time in contrast with a “low-probability” trade. It’s all about your adjustment plan and risk management.

By Seth Freudberg and Michael Schwartz of SMB Capital

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