How to Price and Trade Options: Identify, Analyze, and Execute the Best Trade Probabilities, + Website

CHAPTER 4 Trade Probabilities: What to Look For

Like every other type of investment you make, each option trade should be made with an eye to the risk versus return ratio. In other words, for each unit of risk that you incur in a trade, you should expect a commensurate return. What does that mean in practice and how can we assess what a reasonable risk versus return ratio might look like? While there are no hard and fast rules, it is important to examine the difference in nature of long premium trades versus short premium trades in the context of risk versus return.

First let’s examine long premium trades and what their risk versus return ratio looks like. Earlier we stated that each time you purchase an option you pay more than that option is currently worth. In other words, you pay for both intrinsic value and extrinsic (time premium) value. And furthermore, since the extrinsic value you pay for decays a bit each day, other things must occur with your trade for you to break even, much less turn a profit, on your trade. For example, either the stock must move in your direction or the implied volatility of the option must increase for the value of your option not to decrease by the value of the theta (time decay) each day. Because of this, all other things being equal, long premium trades are considered to have a probability of profit that is less than 50 percent.

Let us look at an example to further drive this point home. On August 1, 2014, with the SPX trading around $1,925, ...