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Option R:R vs. probabilities


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Option R:R vs. probabilities

  #21 (permalink)
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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  #22 (permalink)
 
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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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  #24 (permalink)
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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  #25 (permalink)
 
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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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  #26 (permalink)
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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  #27 (permalink)
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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  #28 (permalink)
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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  #29 (permalink)
 
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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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Last Updated on September 13, 2013


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