How to Estimate Probability of Earning a Profit from an Options Spread Trade

Billy Williams

After I sell and buy my options as outlined in the previous article, I complete my trading plan by consulting a few additional tools to estimate my risk exposure and the probability of making a profit on that trade.

Riding the Trade

My downside will become apparent within the expiration date of the out-of-the-money (OTM) call that I sold. The call will decay and become worthless by April 21 if all goes according to my charts.

I used a simple Monte Carlo simulator to check risk and potential profitability from one of the options calculators.

I am using the calculator at http://www.optionstrategist.com/calculators/probability for a simple analysis. While these calculators are not completely accurate, they provide simple indicators for average probabilities of a trade.

options
Source: OptionStrategist.com

I chose today’s prices for the current stock price, then the strike price for the target. I used the VIX reading for today as the percentage volatility.

The odds seem to be in my favor for a profitable trade, with a 75% chance that the call I sold for April 21 will expire worthless.

Now for calculating the potential for profit.

options
Source: OptionStrategist.com

The farther out the simulation runs, the less reliable the results will be. Still, it gives a perspective that the likelihood of earning a profit is higher by 5% (30%-25%).

One general note about options trading. The farther out you buy your option, the less the time decay of the option will affect you. As you might remember, time decay is the decrease in the value of the option based on getting closer to the expiration date of the option.

Exclusive  Warrants vs Options: Understanding the Key Differences

In this example, I used in my favor the near-term time decay of the call I sold. The time decay for the May call is not quite as fast as the April call, with about a 30-day difference, giving my call more time to move potentially into the money.

Trade Plan

Here is how my trade plan looks for this bull calendar spread trade. Please note the simplicity of my trade plan. You can use a spreadsheet for setting up your own trade plan. You do not need anything complex and you do not need an automatic trading system.

 Sector: Large-cap Index

Sector Major Trend: Bullish

Underlying Security: DJIA

Option(s) Traded: Sell: April DJIA Call @215; CBOE ID: DJX1721D215-E

Buy: May DJIA Call @215; CBOE ID: DJX1719E215-E

Strategies Applied: Bull Calendar Spread

Expected Trade Duration: Between April Call going worthless and highest profit point reached before May Call expires based on trend analysis: probably 25 days.

Max Loss Allowed: Amount of trade $1,000

Triggers for Quick Close: Not necessary as downside is limited.

Potential Upside: Unlimited based on the price of DJIA rising.

Potential Downside: Limited to cost of entering the trade at $1,000

Probability of Profit: 75% chance the call I sold expires worthless and 70% chance that the call I bought goes in-the-money (ITM) based on Monte Carlo simulation.

Once we set up our trades, we can use a variety of tools and calculators to estimate probabilities of earning a profit. Using the theoretical calculators, or Greek calculators as they are commonly known, is typically less helpful than doing basic analysis of the underlying security for the option, choosing a trend, then verifying the option’s potential profit through either our brokers’ calculators or the simple ones mentioned here.

Exclusive  Long Put vs Short Put – Option Trading Strategies

We will use a credit spread trade as the next example because it is one of the easier spread trades. It has a relatively low cost and it carries only modest risk.

There are high-risk versions of this trade, but we will use the low-risk version because that is the focus of this guide.

Tools

Here is a list of a few tools we need.

Options calculator: http://www.optionsprofitcalculator.com/

Theoretical pricing options calculators: http://www.volatilitytrading.net/optioncalculator.htm

And my preferred simple calculator: http://www.optionstrategist.com/calculators/probability

These online calculators will help us identify risk levels, potential profit and general probability for profit with a particular options trade.

After the example for an index (DJIA) here, I will go down the check list and repeat the same steps for another example in a future article. However, this time I will use an equity to review the process one more time.


Billy WIliams option spread strategies

 

Billy Williams is an author and a 25-year veteran trader. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.

 

Like This Article?
Now Get Mark's FREE Special Report:
3 Dividend Plays with Sky-High Returns

This newly-released report by a top-20 living economist details three investments that are your best bets for income and appreciation for the rest of the year and beyond.

Get Access to the Report, 100% FREE


img
previous article

This article is aimed at helping to choose which direction to take in a spread trade, along with the strategy, the timeframe and the trading vehicle. These steps build upon my previous article, which looked at the Dow Jones Industrial Average (DJIA) chart for the last six months and found indicators point to a bullish trend. For simplicity, I chose to forego any neutral option spread trading strategy with a bullish tilt and stick with a basic bullish strategy.

Choosing directi

PREMIUM SERVICES FOR INVESTORS

Dr. Mark Skousen

Named one of the "Top 20 Living Economists," Dr. Skousen is a professional economist, investment expert, university professor, and author of more than 25 books.

Product Details

LEARN MORE HERE

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

Product Details

LEARN MORE HERE

Jim Woods

Jim Woods has over 20 years of experience in the markets from working as a stockbroker,
financial journalist, and money manager. As well as a book author and regular contributor to
numerous investment websites, Jim is the editor of:

Product Details

LEARN MORE HERE

Bob Carlson

Bob Carlson provides independent, objective research covering all the financial issues of retirement and retirement planning. In addition, Bob serves as Chairman of the Board of Trustees of the Fairfax County (VA) Employees’ Retirement System, which has over $2.8 billion in assets.

Product Details

LEARN MORE HERE

Mike Turner

Mike Turner’s financial, mathematical, computer science and engineering background serves as the foundation for his disciplined, rules-based approach to trading. Mike’s three services include:

Product Details

LEARN MORE HERE

Hilary Kramer

Hilary Kramer is an investment analyst and portfolio manager with 30 years of experience on Wall Street. Since 2010, Hilary's financial publications have provided stock analysis and investment advice to her subscribers:

Product Details

LEARN MORE HERE

DividendInvestor.com

Used by financial advisors and individual investors all over the world, DividendInvestor.com is the premier provider and one-stop shop for dividend information and research.

Product Details

Popular tools include our proprietary Dividend Calendar, Dividend Calculator, Dividend Score Card, and many more.

LEARN MORE HERE