Many people are searching for the secret to trading stocks and options profitably. Infomercials abound with a variety of schemes for unlimited wealth with minimal effort. In the options trading world, many firms promote a particular trading strategy as the "holy grail of trading" or the "low risk and high returns" options trading strategy. The reality: this is all marketing hype. Success in stock and options trading requires knowledge, hard work, and discipline. It isn't easy and it isn't quick. But success in stock and options trading is quite achievable; you don't have to be a rocket scientist. You don't have to know "guest post".
The pricing of stock and index options is rooted in probability distributions - the classic bell shaped curve. When I buy or sell an option, the price I pay or receive is derived from an estimate of the probability of that option's worth at a point in the future. One of my favorite options strategies is the iron condor spread.
Recently, I established an iron condor spread on the Russell 2000 Index (RUT) with 690/700 call spreads and 560/570 put spreads with the RUT at $633. The probability of the index closing at a value below $690 at expiration was 86% and the probability of RUT closing at a value above $570 at expiration was 91%. This looks like an excellent trade with a high probability of success.
If we were to construct a trade just like this every month, we could expect to achieve our maximum profit of $3,200 about 86% of the time, but take the maximum loss only 14% of the time - so far, so good. We can compute what is known as the "risk adjusted return" or the return we could expect on average over a large number of trades by:
Risk Adjusted Return = [(0.86) x (3200)] - [(0.14) x (16800)] = $400 or 2%
So we would expect to roughly break even or even lose a small amount over time after placing the iron condor spread on the Russell 2000 Index month after month. But this should not be surprising when we consider that the pricing of options is fundamentally rooted in the probability distributions.
So is all of this talk about options trading just a scam? Is it possible to make money trading options? As in many things in life, the answer is "Yes... and no".
All options strategies, over time and many trades, will lead to the same result: a return close to zero or perhaps even a little negative after commissions and slippage. But it is possible to shift the probabilities in your favor. Assume for a moment that you have discovered a method of adjusting your iron condor spreads so that the maximum loss you take in the months where the index moves against you is limited to an amount equal to our maximum gain in a good month. Now our risk adjusted return equation looks much more promising:
Risk adjusted return = [(0.86) x (3200)] - [(0.14) x (3200)] = $2,304 or 14%
Now we have a trading system that has a probabilistic edge. In fact, this is consistent with the experience of many options traders who started trading the iron condor and thought they had found a wonderful high probability trading strategy. Then the market moved against them for one or two months and they found that they had lost more money than all of their gains to date.
In fact, profitably trading the iron condor, or any options strategy, is quite feasible. But it is only feasible when you have a robust risk management system incorporated into your trading plan. Beware the marketing of the "best" trading strategy that is going to solve all of your problems. That is an illusion.