I recently discussed the ability to use implied volatility to calculate the probability of a successful outcome for any given option trade. To review briefly, the essential concepts a trader must understand in order to make use of this helpful metric include:. These derived values are immensely important for the options trader because they give definitive metrics against which the probability of a successful trade can be gauged.
An essential point of understanding is that the derived standard deviation gives no information whatsoever on the direction of a potential move. It merely determines the probability of the occurrence of a move of a specific magnitude. Black swans do exist and have a nasty habit of appearing at the most inopportune times. For those not familiar with this strategy, it is constructed by selling both a call and put credit spread.
The short strikes of the individual credit spreads are typically selected far out of the money to reduce the chance they will be in-the-money as expiration approaches. I want to build an iron condor on AAPL in order to illustrate the thought process. August expiration is 52 days from today; this is within the optimal day window to establish this position. Consider the high probability call credit spread illustrated below:. Now let us consider the other leg of our trade structure, the put credit spread.
Illustrated below is the other leg of our iron condor, the put spread:. As the astute reader can readily see, this put credit spread is essentially the mirror image of the call credit spread. The resulting trade consists of four individual option positions. It has an absolute defined maximum risk. Another characteristic and reproducible feature of this trade structure is the inverse relation of probability of success and maximum percentage return.
As in virtually all trades, more risk equals more profit. I think this discussion illustrates clearly the immense value of understanding and using defined probabilities of price move magnitude for option traders. Understanding these principles allows experienced option traders to structure option trades with a maximum level of defined risk with a relatively high probability of success.
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Consider the high probability call credit spread illustrated below: Illustrated below is the other leg of our iron condor, the put spread: When considered together, we have given birth to an Iron Condor Spread: Audio interview with J. Probability Based Option Trading.More...