Low Probability Trades

Almost every option ‘expert’ will tell you that any trade that has a high reward/risk ratio will have a low probability of profit or success. And they’d be partially right. But they wouldn’t necessarily be profitable. In fact, I think there’s a high probability that most high probability traders are not profitable in the long run because a trade that has a low probability of profit at expiration can have a very high probability of profit at some point during the trade and vice versa! The key to success is how those trades are managed and in making sure that the trade is initiated with plenty of time until trade expiration. This is generally not a 1-2 week trade strategy. I’ll typically use at least 1-6 month’s DTE. Confused? How about instead of trying to prove that point to you I’ll instead show you how I make low probability trades work for me with a specific example.

In order to initiate a new low probability trade I first need a setup on a chart. I’m not going to go into the setup in this post but if you’re interested you can find a huge amount of material covering my price action and chart analysis elsewhere on this blog or on the twitter feed.

On January 24th I posted this bullish reversal option strategy on another site. This post was about utilizing an OTM (out-of-the-money) Butterfly or Condor option strategy. If you’re not familiar with those strategies you can find information about them anywhere on the internet (including this blog). In the meantime, you don’t need to be an expert in option strategies to understand the idea behind this trade. I wanted to get long Deltas on what I perceived to be a bullish reversal on the SPX daily chart but, I didn’t want to risk a lot of money. If I was wrong then I wouldn’t lose too much and if I was right, I could make multiples of what I was risking. Read what I posted on that site below.

You can see that the total amount of risk I was taking was $280 (plus commissions) and the maximum profit was $2,200. That’s a reward/risk ratio of almost 8:1. Because I was risking what would be, to most traders, a relatively small amount it meant I could stick with the position even if price initially went against the trade. The traders who use high probability trades experience just the opposite effect. The typically risk 2 or 3 or 4 or more to make 1. That means that if price goes against their trade soon after they place it they experience a relatively large loss and, due to that effect, often close out the trade with a loss. Below is the current risk profile of that OTM Broken Wing Condor mentioned in the January 24th post. The SPX is still 75 points away from being ITM (in-the-money) and yet the position has a 146% return on risk. Not bad, right?

And here’s where you learn about reducing risk on a trade and turning a low probability of profit trade into a high probability one! I refer to the process of reducing risk as Delta Hedging (DH) because as the dollar risk is reduced so is the directional (Delta) risk. As of yesterday’s (Friday, February 4th) close, the adjustment shown below was available. I could have ‘rolled up’ the 4575 strike to the 4580 strike and received a credit of $1.80 ($180). That would take my risk on the position from $280 to just $100. The maximum potential profit of the position would then also be reduced from $2,220 to $1,900. While nobody likes to give up potential profits, consider the reward/risk ratio. It was almost 8:1 originally and, with this adjustment, that ratio would go to 19:1. I’ll bet you’d be ok with that! That adjustment would also cost me on the backend of the position. Before the adjustment I could do no worse than have a $220 profit no matter how high SPX went and now the position would be a standard Condor where I could lose $100 if SPX was above 4721 at Feb18 expiry. Still, a fair tradeoff in my opinion because I’ll have the opportunity to exit the position for a much greater profit then the current $410 if SPX continues to rally. If I waited to make that adjustment and SPX continues to rally I could actually get to a position where I could eliminate all possibility of a loss and guarantee a profit no matter what price SPX gets to by expiration. That then becomes the highest probability of profit trade possible; a 100% probability of profit!

So that’s the post. Look around the blog and see how much you can learn. If you have any questions or comments, leave them down below or tweet at me. Cheers!

Update: I’m answering a great question just posed to me on twitter. The question is: how do you handle the trade if it moves against you from the start, before you’ve managed to delta hedge to mitigate risk? My answer: The concept of initiating low probability trades is based on the fact that I like low initial cost trades that have the potential of having a large payout. Because it’s low cost, even if the trade moves against me immediately after I place the trade, my loss is small because my initial risk is small. In this post’s example I was only risking $280 with the potential of making up to $2,220 so even if SPX moved dramatically lower I’d likely be able to limit my loss to less than $150 or so. If I have managed my risk properly at trade entry, that $280 is the amount that I’m willing to lose on this trade. That’s essentially my stop loss! What makes that better than an actual stop loss is that an actual stop loss takes me out of a trade while this virtual stop loss keeps me in a trade so if SPX spikes down and then reverses hard to the upside I’m still in the trade at a time that many others were stopped out at exactly the worst time! So the bottom line is I keep my trades small enough that I’m able to lose the entire amount without damaging my portfolio. That doesn’t often happen to me because if SPX went much lower then my chart analysis would signal a bearish reversal and I’d likely either exit the trade or add a new bearish trade to take my portfolio to short Deltas.