High Probability Trade Dilemma

Posted on August 30th, 2012

We regularly write about high probability credit spreads on this blog and typically on a monthly basis, we’ll outline the strikes and entry / exit points and some other info pertinent to the trade.

If you’re not familiar with this tactic, here is a link to the article we published in SFO Magazine on March 1, 2010 titled: Take Steps to Generate Income with Credit Spreads.

This month we’re going to outline choosing between a bullish or bearish spread. For readers of the Buy and Hedge blog, you’ll know that we’ve outlined over the last few weeks that the market seems to be pressing up against the upper range and if we had to pick (and we try not to), we estimate that the market will be lower in 30 days vs. higher.

This bias, however, this doesn’t necessarily mean we take a bearish position when putting on the credit spread for this month. We let the data tell us where the best risk / reward ratio exists.

As a review, we use probabilities to assess risk for this trade, and we look for trades with a very high probability of success; hence the strategy name. The probability we look for is the chance that the trade will be profitable. Actually, we look for the probability that short leg of the spread expires out-of-the-money. For a bull credit (put) spread that means above the strike price and for a bear credit (call) spread the means below the strike price.

Said another way, when we are in a bull put spread, we want the underlying index to end above the upper strike price (short leg) at expiration. The opposite is true for the bear call spreads. 

Next we want to make sure we’re getting rewarded for the risk we’re taking the matches or exceeds the risk (i.e. probability the trade loses money). We use these two data points to help us find the right strikes for our trade.

When assessing which strikes to put on each month, we always look at the calls as well as the puts. To be honest, we really don’t care which side of the market we’re on as long as we have the best risk/reward ratio. Remember, a credit spread pays its max value when it expires worthless. So it doesn’t make much of a difference if the market moves slightly in your favor or dramatically in your favor. The trade pays the same no matter what.

Using the SPX as an example, here is what the data looks like when we pick a bull and a bear credit spread equidistant from the current price of 1400. Since the SPX at the time is at a nice even number, we’ll look at strikes 100 points (7%) on either side for simplicity purposes. These aren’t necessarily the trades we would place, but makes for an easy comparision.

Bull Put Spread
  • Current SPX Price:  1400
  • Strikes:    1300/1275
  • Probability of SPX < 1300:  4.8% 
  • Credit     $1.10
  • Reward %:   4.6% (1.1/23.9)
  • Reward to Risk Ratio: 0.96 (4.6 / 4.8) ←  

Bear Call Spread
  • Current SPX Price:  1400
  • Strikes:    1500/1525
  • Probability of SPX > 1500:  5.9%
  • Credit     $0.10
  • Reward %:   0.4% (0.1/24.9)
  • Reward to Risk Ratio: 0.07 (0.4 / 5.9) ←

Looking at the reward to risk ratio of the bull vs. bear (the higher the better) we can see that the bull trade is at least an entire order of magnitude better: 0.96 vs. 0.07.

Let’s ask it in plain English. Would you rather take a 4.8% risk to earn 4.6% (bull put spread) or take a 5.9% risk to earn 0.4% (bear call spread)? Hopefully you can see that more risk and less reward (the call spread) is clearly the wrong answer and that the bull put spread is the right one.

Getting back to our dilemma. The issue is that our thesis about the market conflicts with the bias of our trade.

The answer comes down to removing emotion and following what the numbers tell us, and that is, based on this real data, go with the bull trade. Remember, there is a 7% cushion for the market to move against the bull spread before the upper strike gets in the money. That means that the market can do down modestly and still let this bull put spread be profitable. In other words, the market can stay flat, go up, or go down slightly and this trade will still pay the same return.

The trade fails catastrophically when the market goes down quickly and dramatically. So be sure to know your exits and get out based on the rules outlined in the SFO article. Avoiding the big loss has to be priority #1 with this trade and that means keeping a vigilant eye on it.

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Aristotle - August 31st, 2012 at 9:45 AM
Very informative article!

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