So you’re thinking about buying a stock and feeling pretty good about its potential.
You’ve done your research, checked the news items and looked at the support and resistance levels on the charts.
You’re ready to pull the trigger.
But do you really know what your odds are, or the probability of the stock moving in your favor?
Just like a flip of a coin, there’s only two outcomes for a stock: higher or lower. So that first tick after buying the stock has no more than a 50% chance of going where you need it to — higher.
Buying stock is a 50/50 proposition. Is that all you want from your trades?
I’ve traded stock long enough to know that eventually most will move higher. But that’s only if you pick the right stocks. Think about all the duds you may have purchased over the years due to a “hot” tip, or advice from your neighbor.
Many of those losers have unfortunately outweighed the wins. And even if you did buy the right stock, did you have the patience to wait out the long spells of down-moves and sideways trading before it eventually moved higher?
I bet the moment that you might have given up on the stock or it hit its stop-loss level, that’s when it started its ascent. Right? And you sat there cursing at your trading screen because now you weren’t participating.
Been there, done that. It’s happened to the best of us.
So how about I show you a way to get much higher odds on your trades so you can be a happier trader.
Know Your Odds
Many of the option trades that I make are taken from the mindset of where I think the stock is “not going” versus where I think the stock “is going.”
There’s a huge difference in that approach, one which can make a substantial impact on your portfolio balance.
In investing, we’re always geared to figure out where the stock will move to, and we base our trading on that premise.
In the options market, not only do option buyers need to figure out where the stock is going, but they need to know when that move will happen, as well.
Since each option contract has an expiration date, the timing of the intended move becomes extremely critical.
Could you tell me when Microsoft (Nasdaq: MSFT) is going to reach $150 per share (it’s currently at $122), and when it will get there?
Or maybe you’d say something like, “Someday it will.”
Well, people who buy options contracts, specifically call option contracts, are doing just that. They think they know what price the stock will go up to by a certain date.
Same with put options. These are contracts that can be purchased to speculate on a down move. Can you tell me when MSFT will hit $75 again, and when?
Well, anyone who’s buying put option contracts are doing just that.
And you know what kind of track record these option buyers have? A miserable one.
I’ve shown this graphic before, but it bears repeating.
Based on a study performed by the Chicago Mercantile Exchange, 93.9% and 95.2% of put option contracts on the S&P 500 and Nasdaq 100 expired worthless between 1997-1999.
This meant that anyone who bought put options on those two indexes during that timeframe had losses up to 95.2% of the time.
One of the main reasons why? Because the stock market continually goes up over time, not down. In order to win with buying put options, you need the market to go down.
And who were the winners in this case? The put option sellers.
Continual up-moves haven’t changed either since 1999. Yes, we’ve had some pull-backs, two of which were major (2000 & 2008), but the stock market has just hit new all-time highs.
Anyone buying put options along the way has probably suffered the same bad fate.
The Best Tool
One of the greatest financial tools I’ve found during my years of trading is the probability calculator.
This handy gadget can give you a sense of how successful your trade can be even before you plunk any money down.
It’s especially useful in the options trading world — an arena in which I spend about 99% of my own time.
Since I’m a big proponent of option-selling strategies, I can skew the probability of winning to a very high degree in my favor.
When you choose to execute option trades in which you figure out where a stock “won’t go” versus where it “will go,” it changes the odds immensely in your favor.
Going back to our Microsoft question: Can you tell me the odds of it falling from its current price of $122 down to $75?
Off the top of your head you probably couldn’t. But a probability calculator can.
Based on MSFT’s current price and the range it’s traded in over the last year, the probability calculator can show us there’s less than a 1% chance of MSFT moving below $75 by December 20, 2019.
Said another way, there’s a 99.58% chance that it won’t move below $75 by December 20, 2019.
How does that help me as a trader?
Well, if I’m pretty confident that MSFT is going to move up over time, then I’m even more confident that it won’t move significantly lower over that same time frame (down to $75).
I can make great trades that take that assumption into consideration.
If I sold a MSFT December 2019 $75 strike put option, I would be paid $.43 for it. Meaning, I would receive $43 (using the $100 option multiplier) into my trading account.
And if you’ve read the multitude of articles I’ve written in The Rich Investor about selling put options, you would know how I love the strategy.
Come December, if MSFT is still trading above $75, I keep my $43. If it moves below $75, I get to buy 100 shares at a really, really good price ($75).
Anyone who bought that $75 put option not only needs MSFT to fall over $47 per share, but it has to occur by December 2019. The odds of that happening? Less than 1%. Bad!
Knowing your odds before taking a trade can greatly improve your win rate, and fatten your wallet. That’s what I like.
Consider consulting a probability calculator before your next move.