Updated: May 30
As you may know, options trading is my specialty, especially put-option selling.
One of my goals is to educate my readers in understanding the finer points of option selling, which can allow them to become smarter traders and help them make more money from employing the strategies I outline.
One of the biggest determinants of successful option trading is the concept of probability.
When you are an option buyer, you are tasked with not only trying to predict the direction of the stock, but also with when the stock will make that move (expiration date).
In essence, you have to be a really good predictor of the where and when of a stock move.
That's when probability really comes into play, because if the stock doesn't make the intended move by the expiration date, you will lose your entire investment (option premium).
So it would be in your best interest to understand the probabilities of a stock getting to a certain level by a certain time.
In the studies that I have seen, and the 26 years of experience that I have, I have come to the conclusion that option buying is a loser's game, especially if you're buying out-of-the-money options.
The reason being? Because the probabilities of the stock reaching those out-of-the-money levels is extremely low.
But what if I told you there's a way to see the probabilities ahead of time of a stock getting to a certain level by a certain date? Would that interest you?
If so, you'd be able to make much smarter trades as it would almost be like looking at a crystal ball giving you clues to where a stock will go and by what time.
Why Probability Is So Important
At this point you're probably thinking, "this is going to make buying options so much easier".
But you'll soon see that the crystal ball still shows that the probabilities to win are so small for option buyers, that you'll quickly convert to option selling.
You see, as an option seller, we don't have that pressure to make the prediction of where the stock needs to go. We only need to be concerned with where the stock probably won't go.
That's a big difference. Think about it...
If you bought a $50 put option on a stock that is currently at $60 per share, you absolutely need that stock to fall below $50 in order to make a profit (if held to expiration).
But if you sold that same $50 put option, then you can still profit if the stock goes up, if the stock stays stagnant, or even if the stock falls (but not below $50). That's three scenarios for the put-seller to profit vs the one scenario for the put-buyer.
The put-option seller will only lose in this case if the stock falls below $50, but will win if the stock trades anywhere from $50 to infinity. That's a nice profitability range.
The stock's currently at $60, so the put-option seller already has a $10 cushion built-in above the $50 danger zone.
The put-option buyer can only win if the stock falls below $50. That's the only way.
So now that we know the where the stock needs to get to for each party, let's see what our crystal ball is telling us.
The Crystal Ball
A probability calculator is our tool of choice, and we use it to help us gauge the probabilities of stock prices reaching a certain level by a certain date. It's our crystal ball!
Let's take a look to give us a visual of the odds we have on our side as put-option sellers.
As we look at the calculator above (which is on our site here), we've used the sample $60 stock with the goal of it reaching $50 in our typical four-month time frame.
As you can see from the bottom-left box, this stock, based on its 20% volatility (typical for most stocks), has only a 5.6% chance of finishing below $50 at the end of four months.
Who wants to make a trade that only has a 5.6% chance of success? Not me!
That's why we as put-option sellers have a 94.4% chance of success on this typical trade, as shown in the bottom-right box. That 94.4% is the odds of the stock remaining above $50 at the end of four months (expiration date).
If the stock ends above $50 at expiration, the put-option buyer loses 100% of their investment (option premium) and the put-option seller keeps 100% of that investment.
You see, most option investors (buyers) have no clue about their odds of success at the outset of their trade. They don't know the probabilities. But we do!
That's why most of our trades at The Smart Option Seller fall into that category of 90%+ chances of success, and how the probability calculator helps us figure out where the stock most likely won't go.
This is the basis of our whole put-selling strategy - we find stocks that have such a low probability of getting to a certain area, and then we sell put options that match that price level, giving us very high odds of winning.
The crystal ball is a huge help, and we never fail to use it. You should too!
But you have to know which stocks to look for and which strike prices to look for, and what expiration dates to look for.
This is where The Smart Option Seller newsletter comes in. We do all the heavy lifting and give you all the details on which stocks to use, which strike prices to use and which expiration dates to use.
I hope this post was educational, and if you'd like to read some more about why selling put options is so high on my list, click the links below:
Send me your questions here if you have them. I'll always answer.
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