Identifying High Probability Trading
This is all about high probability trading – and that means finding Ultra-Low Delta commodity options to sell. By high-probability I mean finding those options to sell and collect the credit into a trader’s account immediately – and only selling options that have a very high probability (like the 97% trade illustrated below) of expiring worthless / OTM -Out-of-The-Money.
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Here’s an example: It is now mid-October 2018, the Crude Oil contract for April 2019 is trading at $71.14 per barrel. When I sell a CALL option with a strike-price of $100 per barrel, this means that unless Crude Oil prices are $100 or higher, I get to keep the option premium I collected of $140. The deadline date, which is called the option expiry date for the April 2019 option class is March 14, 2019, about 150 days out in time. I have to post a net initial margin deposit (which means I must have these funds in my account balance as I place the trade) of $370. That a potential return of over 36% in only five months!
This short APR2019 Crude Oil $100-strike CALL option has a “Prob OTM” – Probability of Expiring Out-of-the-Money of 97%. A simple way of computing the Prob. OTM is just to subtract the option’s delta from one. The Delta of this option is 0.03. Therefore the Prob. OTM = 1.0 minus 0.03 = .97 or 97%. Remember, low delta means high probability.
Here’s the chart of April 2019 Crude Oil (/CLJ19):
The risk of selling naked options is theoretically unlimited. Usually, when I sell commodity options, if the premium doubles, I will exit the trade as a safety limit. This practice keeps losses down to a manageable amount and since over 90% of these high-probability trades have been winners, the profits far exceed the small losses. This type of trading can be risky and is not suitable for all investors. Selling options with the as low delta as possible, means they are far enough OTM that if a market turns the wrong way you’ll have plenty of room to get out of a trade. See: 200% rule for money management
Probability Computations
This is high probability trading – using a formula similar to the Black-Scholes-Merton modeling.
The “Prob. of OTM” does NOT consider a market’s fundamentals, it only uses:
- The volatility of the underlying contract
- The distance the option’s strike and price of the underlying
- Current interest rates
- And the option’s value
This calculates a likely percentage based on the distribution of probability curve – similar to what you may know as a Bell curve.)
Distribution of Probability, a Nobel prize-winning derivation – is widely used and accepted as the standard by insurance companies, casinos, and hundreds of other applications and businesses. It computes the likelihood of an occurrence based on mathematical modeling systems. In stock and commodity options, the main factors formulated are the volatility of the underlying stock or commodity – and how far the strike-price of an option is from the price of the underlying stock or commodity.
On 14 October 1997 the Nobel prize awarded by the Bank of Sweden- designated the Prize in Economic Sciences in Memory of Alfred Nobel, 1997, to Professor Robert C. Merton, Harvard University, Cambridge, USA and Professor Myron S. Scholes, Stanford University, Stanford, USA for a new method to determine the value of derivatives. Fischer Black & Merton developed the work in the late 1960’s. This formula has led the way to a boom in options trading and provided mathematical legitimacy to the activities of the Chicago Board Options Exchange and other options markets around the world. It is widely used, although often with adjustments and corrections, by options market participants.
Modern trading platform software now use this Nobel-winning math in smart phones, tablet devices, and desktop computers in super-fast background transparency to calculate probabilities for option traders using on-line trading. Only recently, just in the last few years, has broadband internet, and inexpensive technology made this type of trading available to small and medium personal investors. Previously only wealthy investors and professional money-managers could afford the access to use these trading methods. Now, it is available to almost everyone – and the popularity of this trading is steadily growing in leaps and bounds.
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Thank you – Don
Don A. Singletary
