March 24, 2016
Shocking Footage: We flew a camera to the outskirts of Chicago to film the price war Bloomberg estimates is worth a “gazillion” dollars. Here’s what we found…
In trading, probability of profits and potential profitability are inversely correlated.
In less scientific terms though, it means that the probability of your profits and how much profits you can make are connected more than you might think.
Higher probability trades offer lower profit potential while lower probability trades offer higher profit potential.
And while being a successful trader is about making money, in some scenarios – probability of profit is more important than how much you can make.
Here’s what you need to know…
As you might know, I’m an options trader. Sure, they take a bit of time to learn, but the benefits are well worth it. I can easily reduce my risk and increase my ROI by 10-fold with options, amongst other things.
But what the novice doesn’t know is that option trades can be constructed to greatly increase your chances of success. I’m talking a minimum of 66% and usually higher.
And I’m about to tell you how to do just that.
It all comes down to the fact that for every buyer of an option, there must be a short seller on the opposite side.
For example, if I were to buy an XYZ $50 call option (go long), it would give me the right to buy XYZ at $50. In order for me to be granted this right, there must be someone obligated to sell me XYZ at $50 should I decide to exercise my rights.
This is all handled by market makers who match up buyers and sellers.
So, for an XYZ $50 call option to trade hands, there are two sides to the trade as shown below with rights and obligations noted:
The long XYZ $50 call only makes money if the stock goes up. Assuming that a stock can move three directions in equal probability, a long call makes money 33% of the time, statistically speaking.
Now, when one side wins, the other loses.
So, if the long call has a 33.33% probability of profit, it follows that the short call will have a 66.67% probability of profit.
In other words, the simple act of shorting an option provides a 66.67% probability of success, generally speaking. These odds do vary depending upon where the option strike price is relative to the stock price, but they’re still a LOT higher than buying long options.
Shorting options also carries with it unlimited risk, so you have to be careful and buy an option along with the short option to create a spread. Done right, spreads still carry the same probability benefits as short options alone.
So, what’s a “spread?”
Simply put, a spread is two or more option legs placed together as a single trade.
A long call debit spread is constructed by buying a lower strike call and selling a higher strike call. Buying a call gives you rights and selling a call short gives you obligations.
Here’s an example of a long call spread:
Placing these two legs in a single trade as a package will yield a net debit, or in simpler terms – how much you have to pay for this trade setup.
The maximum value of the spread is the distance between the strikes. In this example, the XYZ $50-$55 Long Call Spread has a maximum value of $5.
But if you buy this spread for $2.00, the most you could make would be $3.00.
For the spread to be at maximum value, the stock will need to be at or above the short strike at expiration. In this case, if the stock is > $55 at expiration, this whole spread will be at max value.
Now, here’s where the probability comes in…
If you place a long call spread at or below the current stock price, you automatically receive at least a 66.67% probability of profit – or higher.
Take a look at the following long call spread on CGC.
With CGC trading at $52, you can harness high probability with the following trade:
Both of these legs are In-The-Money (ITM), which means that the strike prices are both below the stock price. ITM spreads expire at maximum value, which means maximum profit for you if you own a spread like the one pictured above.
But if you buy this spread for $3.40, the most you could make would be $1.60 as you can see above.
Now, a 47.06% ROI may not seem like much, but when you consider that you have over a 66% probability of making 47.06% – that dog will hunt.
And as you can see in the chart below, this ITM spread makes money as long as the stock (currently at $52) doesn’t drop below $50.
The stock can go up, sideways, and down $2 to $50 and it will still yield a 47% profit – and that’s the power of this lucrative setup when backed by high probability.
Now, it’s important to realize that if the stock rises from here, a long call will usually make more money than the ITM spread – but, the probability of that happening is less – making the long call spread the better option for your bottom dollar.
And that’s the power of probability – you’re ready to trade like the pros.
America’s #1 Pattern Trader
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