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Trade Options with a 90% Probability of Success

By Kerry Given

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Published: 02Sep2009
Word count: 506
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It is common to see web site banners or other advertisements similar to the title of this article, touting the benefits of options trades with probabilities of success of 85-90%. Technically, these trades indeed have a high probability of success, i.e., if you placed a trade with the same parameters every month of the year, you should see about 10 or 11 trades per year be successful and one or two be losers. And the longer you traded in this way, the more likely your results would conform to these averages.

The underlying probability calculation assumes that the stock price movements are random events, like throwing dice. Of course, stock price movements are not purely random, but are affected by news, rumors, crowd psychology and many more factors. But it isn't a bad approximation for the reality, especially when averaged over many stocks and over long periods of time.

The essence of the problem derives from the old financial adage, there's no free lunch. If you were to establish trades with these probabilities, the returns will be rather small, of the order of 7% to 10%. But the losses would be huge, of the order of 90% to 100%. The bottom line is that the one or two losses each year would be large enough to wipe out all of the gains for the year. Thus, there is only a small probability of a losing trade, but when it happens, it will be a devastating loss.

Some traders will claim that these high probability trades don't make sense, and will sell the idea of so called "low risk" trades, where the potential loss is small, hence the label of low risk. These trades are simply the mirror image of the high probability trade. The low risk trade is characterized by a huge potential gain, of the order of 200% or more, but there is a very small probability of that successful outcome. In this case, one would lose a small amount on the trade 10 or 11 months out of the year and then have 1 or 2 large gains. The problem is that the large gains would not compensate for the large number of small losses. In either case, the outcome is the same, a small net loss, especially after commissions and other costs of trading.

So is options trading inherently a losing game? No, not necessarily, there are many examples of successful, long term options traders. They succeed by paying attention to two critical factors: 1) keeping one's ratio of winning trades to losing trades as high as possible, and 2) minimizing the losses on the inevitable losing trades. But those topics require a much more extensive treatment than can be done in a short article. One's choice of either the high probability trade or the low risk trade is not a financial issue - neither is inherently superior. Neither trade will be successful long term without other considerations. One's choice of the high probability or the low risk trade is primarily a matter of matching one's trading style and risk tolerance with the right trade.

Kerry W. Given, Ph.D., aka Dr. Duke, has over twenty years of experience investing in the stock market and over seven years experience trading equity and index options. He has taken many classes on investing and trading through the years and has discovered first hand how difficult it can be to separate the financial facts from the marketing hype, myths, and get rich quick schemes. He can be reached at: ParkwoodCapitalLLC.com

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