Many traders have been attracted to options strategies that promise a high probability of success. Examples include deep ITM bull call spreads, far OTM credit spreads, iron condor spreads and many others.
High probability options trades are inherently high risk/reward trades, i.e., the maximum potential loss is much larger than the maximum potential gain. The probability of a loss occurring is small, but if it occurs, it will be quite large and will wipe out several months of gains.
Thus, high probability options trades necessitate a robust system of risk management so the trader can be reasonably sure she never takes that maximum loss. Let's take the iron condor as an example. This is a popular trade largely because of the high probabilities associated with the set-up. Establishing a trade with a 85-90% probability of success is very attractive. But risk management is crucial, as many have found out the hard way. Let's assume we are trading 20 contracts and establishing the condor in such a way as to collect a credit of $3,500 each month. We are successful for three months running and now have a nice $10,500 profit. But the market moves strongly against us the following month and we take the maximum loss of $16,500. Now we are $6,000 in the hole and will need two good months just to break even. A good risk management system ensures we never take that maximum loss and makes it feasible to be profitable in the long term.
If you have traded high probability option spreads, you may have wondered why the probabilities of success can be so high and yet the trader has to make frequent adjustments to the position. If my trade has a 10-15% probability of loss, one might reasonably expect to adjust about 10-15% of the time. But that isn't the case.
Take the track record of my Flying With The Condor™ trading service as an example. In 2011, we placed one iron condor spread each month on either the Standard and Poors 500 index (SPX) or the Russell 2000 index (RUT). Each of these trades were positioned to have a probability of success in excess of 85%. So we might reasonably expect to adjust the position about two months out of the year. The actual results included adjustments nine out of the twelve months; only three trades required no adjustments. In fact, several of the positions required five or six adjustments.
The underlying reason for this "real life" deviation from the theory is this: the low probability of the index closing within one of my spreads is accurate; but the probability of the index trending and touching one of my spreads before pulling back is actually much higher. Thus, adjustments are required more often than would be predicted.
Our Flying With The Condor™ service took two losses in 2011, one for 2% and one for 5%. The net gain for the year was 39%. That's pretty impressive compared to the Standard and Poors 500, currently down about 3% for the year. That is the power of risk management. If you can avoid the big losses, you can be profitable in the long term with high probability options strategies.
If you would like to learn more about managing and adjusting non-directional options strategies, check out the ten week webinar series that will start the week of January 9.