Thanks for the posting. After reading so many reader's question, I am
curious about how you personally see this thing: The role of
probability in option trading.
Just as we discussed last time – the market return is actually a
"fat-left tail bell-shaped distribution" (Ok, similer to normal
distribution but not exactly). So, it means that, a "market direction
neutral" strategy is possible, given the probability distributions of
the broad market return have been relatively very similar across time.
Just by strict risk control, is "trading probability" an feasible way
to survive in the market???
Personally,even though I do see a lot in probabilities, the
"expected value" is never in my trading plan. I know too well that,
when, the tail risk happens,even if, I do spreads, and as long as I put
all of my eggs in one trade,then I am still a dead body — this has
nothing to do with "expected value". So my biggest plan is always
ex-ante risk control.
Thanks in advance if you can share your view on the "probability trading" way.
It's not just probability. It's also about profit potential.
You cannot evaluate whether to accept a specific probability of success without knowing how much can be earned. That's why I try to find a compromise between going as far OTM as possible (HIGHEST probability), with a GOOD profit possibility (not too far OTM).
No risk is worth taking, no probability of success is high enough when the reward is too small to justify the risk.
In short, I don't dwell on probability. But that's because the option's delta already provides a good picture of probability (of a sold option expiring worthless) and I already took it into consideration when choosing my strike prices for an iron condor trade.
As you note, we do have a fat tail problem on the left (down) side of the curve. I take care of that problem in one of two ways. I can trade less size (my current method), or I can buy insurance (which I prefer, but I only do that when option prices feel reasonably priced).
I am content to trade less size and keep cash in reserve because it reduces stress and allows me to adjust a trade with less pressure (threatened loss is less). Sure, the profits may be reduced, but that's the trade off.
As a side comment, this has been working well. June and July were my two best months since I trading iron condors, and even with reduced profits, I am satisfied. My results were far worse earlier in the year when I was trading more size.
Henry – if you are protected from being killed, that's a good thing.