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.
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.
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.
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.
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.
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.
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 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.