Tuesday, November 30, 2010

How to Trade With Better Than 50/50 Odds

When does a 50/50 bet not have even odds? If your answer is any betting game in Las Vegas, you are right. In the casino, the odds favor the house. If you can find a bet in Las Vegas (or Atlantic City or Macau) that pays better than even odds take this advice: Don’t tell anyone, and play that game small as often as you can until you are rich.

In the option trading world, these types of trades are also few and far between. Like gambling in a casino, if you find a stock or options trade that pays better than 50/50 odds, keep it to yourself, trade small over and over until you are rich.

While these types of true arbitrage trades almost never happen, sometimes there are opportunities to put on trades that seem to have better than 50/50 odds. This is because options are multi-dimensional. When purchasing an outright call or put, the trader is making a bet that the market (or stock) is going to move in the preferred direction AND that the implied volatility (IV) will hold stable or increase. The same holds true for shorting options.

We are currently in a cycle that has the implied volatility of S&P 500 (SPX) options falling. This makes sense considering realized volatility is very low as well. Does this mean that owning options is a bad idea? Sometimes, YES! However, there are moments where it can make a ton of sense to buy options. On Nov. 24, the day before Thanksgiving, I actually bought a few puts. (more)

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