Tuesday, January 24, 2012

Credit Put Spreads Part 3 - Probabilities

3.       Probabilities – although anything can happen. Bad company news, lawsuit, government legislation, flash crash, etc. the most important part of the credit put spread strategy is to enter into trades with a very high probability of achieving a profit. You have to decide early on that entering into these credit trades is to make money; it is not to “play” some event like earnings. It is not like going into a casino, it is not a game of chance. Options are priced to reflect the current probability of future price movement. Most broker websites have options calculators included to determine the probability of profits. Trademonster has this available under the Analyse tab. I have a goal/ guideline that put credit spreads will only be entered if the probability of max profit is 75-80% or higher. A 50% probability is essentially a coin flip. You would not bet money on a 50-50 scenario but would likely bet if the probability of a coin flip coming up heads was 85%. You would obviously bet on the 85% side. Most trades are in the 85-90% probability range. Anything below 75-80% is usually eliminated from consideration. Although there are plenty of profitable trades to be had with probabilities under 75% im trying to string together alot of winning trades vs going for the home runs. The probabilities determine if i enter the trade, not the amount of the premium i will receive.  Eliminating the bad trades is the first step in having successful trades.
            For quick mental reference with using credit put spreads.. the "delta" of your short strike put will match up pretty closely with what your max profit probability will be.. example.. delta is .19 then max profit probability will be close to 81%  (100 - 19 = 81)