How Bullish Traders Can Use Probabilities to Maximize Return
Do you ever find yourself in the situation where, you have a lot of conviction that the stock market, or at least a particular industry or sector, will make a notable move to the upside?
Timing these moves can be difficult and even when traders are able to do so, buying the physical stock may still only result in a small return once commissions and fees are taken into the mix. However, using options allows a trader the potential to see a higher return, even if they don’t perfectly time the rally.
Assuming that a trader is relatively accurate on the timing and has chosen the correct direction, the next input they need to figure out is strategy. Should they sell puts, a neutral to slightly bullish position? Should they buy call spreads, a clearly bullish play on an underlying move?
Each situation is different and will call for a specific strategy.
However, there’s one final step that too many investors simply ignore or don’t consider: Probability.
What exactly are they odds that the trade will be profitable? How likely is it that the trade will turn out to be a complete bust? When those answers are question marks rather than percentage points, traders are equipping themselves with a dull edge rather than a sharp one.
That’s why at OptionParty we use three different probabilities, including the probability of profit, probability of target return and probability of total loss. To learn more about these three probabilities, read about it here.
In our first example, let’s say we’re expecting a notable rally in the broader market, but would prefer to play it via the tech sector. It’s early October and we expect the move to happen by the end of the month.
The first trade that we see is a long bull call spread, which says we should buy the Netflix (NFLX) regular October expiration $85 calls and sell the $96 calls. The minimum return we’re looking for is 10%.
The odds that our target return is hit is 72.6%, while there is a 75.6% chance the trade generates a profit of a penny or more. Pretty good numbers, but with an 8.9% chance – almost 1-in-10 odds – that we experience a total loss is somewhat concerning.
While the return on risk is attractive, standing at 14.5%, we feel that there are lower risk alternatives out there. Instead we find:
Buy the Apple (AAPL) October 28th $101 calls and sell the $109 calls to create a bull call spread. While the return on risk of 10.3% is less than the 14.5% return in the first trade, the probability of total loss is lower, at 5.4%.
Along with a lower risk profile, the odds of hitting our target return and probability of profit are both higher than the first trade, standing at 73.4% and 76.3%, respectively.
In this example, both trades have their merits. It merely comes down to risk vs. reward and different traders will view them differently. However, because we used a tight set of parameters, the scan resulted in just 12 potential trades; however, it resulted in the types of trades we wanted.
What About Unsure Bullishness?
Sometimes a trader finds him or herself in a situation where they’re bullish, but don’t have a whole lot of conviction. Perhaps they feel the market may or may not go up, but it seems unlikely it will fall – and at least if it does pull back, it won’t be by much.
In a situation like this – where any movement seems likely to be muted and if there is movement, it’s most likely to come in the form of a small rally – options strategies can still be deployed.
Instead of playing for just a rally or a decline, traders can incorporate neutral movement into their bias. The summer of 2016 has been a great example of this. Since mid-July, the market has gone on a period of incredibly low-range trading. Meaning, the market hasn’t moved much one way or the other.
Selling options in this environment is one way to take advantage of this type of movement. Rather than selling calls and puts, traders can incorporate their bias (either bullish or bearish) by selecting either calls or puts. Let’s look at an example:
Because we are neutral to slightly bullish on the overall market, we will consider selling cash-secured put options and bull put spreads. By selling puts, we are looking for the market to continue on its current path, which is just small moves in either direction. If the market rallies, our position will benefit. If the market falls considerably, that’s where we’ll have problems.
Basically, we are just looking for the market to go sideways to higher over the next few weeks.
Using the same timeframe parameters as the first trade, we could consider selling the Caterpillar (CAT) $84.50 puts and buying the $80.50 puts with an expiration date of October 28th, just a few weeks away.
While the 21.7% return on risk is far about the 6% minimum return we were seeking, there are some other probabilities to take note of. For instance, there is 72.6% chance of this trade hitting its target return and a more than 76% likelihood that it profits by at least a penny. However, the 11.4% risk of total loss is somewhat of a turn-off.
Instead, how about looking for a trade with a bit lower risk, despite the hefty potential payout? By sorting the Option Profit results by risk, we find that selling the VMWare (VMW) Oct. 28th $69.50 puts and buying the Oct. 28th $60 puts is the lowest risk play.
Despite the lowered risk, there’s still a 71.3% probability that it will hit our minimum return of 6% and a 75.9% chance the trade will result in a profit. It should also be noted that despite its lower risk – with a total loss probability of 4% – the reward isn’t diminished too much. There’s still a return on risk potential of 13.4%.
While the 13.4% return on VMW is lower than the 21.7% return possibility from CAT, the lowered risk profile on the second trade may be more suitable for certain traders.
If one is bullish, they will look for way to take advantage of a rally. That’s where conviction comes into play. Are you positive that a move higher is on the way, or does it just seem possible? Depending on how strong one”s conviction is, that could compel them not only to choose different strategies – for instance, buying a call spread vs. selling a put spread – but also, how aggressive or conservative to be with those strategies. The different examples above help demonstrate how factoring in probabilities can aid in those decisions.