Insurance companies collect premium with the expectation of future payouts. By knowing the probability of a claim, they can calculate their expected return for assuming the risk of the policyholder. The insurer is confident that overtime they will profit despite their obligation to pay claims. Casinos successfully operate on a similar premise. They bring in gaming revenue knowing that there are jackpots to be paid, but know that the odds are in favor of the house. Option traders can benefit from the same logic by selling credit spreads. This strategy gives them the ability to capitalize on probabilities, as opposed to entering a position hoping to profit on a “long shot”, as well as limit their exposure to risk.
Credit Spreads
A credit spread is an option strategy that involves the simultaneous sale and purchase of an option with common underliers and expiration dates. As the name implies, the short options must be higher prices than the long, thus bringing a credit to the trader. For example, you may be able to sell a front month Dow 10300 call option for $650, and buy a 10500 call option for $250 to protect your short position. The trader would bring in a credit of $400 as a reward for accepting the risk of the Dow going up. Unlike selling naked options, the risk of a credit spread is limited to the spread between the strike prices minus the premium collected; in this example it would be $1,600.
Is having limited risk worth the opportunity cost?
Obviously, there is a trade off between capping your risk and maximizing premium collected. Armed with the notion that 80% of all options will expire worthless, many traders are tempted to sell naked options. This strategy results in a limited profit and unlimited loss. Even if an investor successfully collects premium 8 out of 10 times, the 2 inevitable losing trades will likely erase previous profits and then some. Have you ever noticed that all insurance policies have a maximum benefit? This is not a coincidence. The insurance firm Lloyd’s of London discovered the importance of limiting losses the hard way. They prided themselves on the sale of “no limit” policies, but in the early 90’s they were averaging close to $3 billion a year due to asbestos claims.
Reinsurance is another way in which insurers limit their risk. After collecting premium on a policy, firms allocate a portion of the proceeds to the purchase of insurance against the sold coverage. Credit spreads can be viewed in the same terms. Following the sale of an option, it is wise to limit potential losses by purchasing protection.
Profit on Probability
Given the overall probabilities involved in option trading, one can expect to collect the premium for selling options nearly 80% of the time. Hypothetically, an option trader could sell 10 credit spreads with payout and risk identical to the above example and yield an $600 profit calculated as follows ($475 * 8)-($1,600 * 2) = $600. While some commodity traders might snuff at such a meager return, in percentage terms the reward exceeds that of most other investment options, including the stock market. If the above example requires $11,000 of margin, an investor would earn a monthly return of nearly 5.5%!!!
“Conventional” commodity traders would be turned off at the idea of a negative risk reward ratio. Risking $1,600 to make $475 may seem to be illogical on the surface, but if you look at the probabilities involved you will find the exact opposite. Frequency of the outcomes makes it advantageous to participate in trades in which the risk outweighs the reward. This is the exact strategy that casinos have thrived off of for years.
Calculating the Probabilities of a Spread
Before an insurance company issues a policy, they compile several pieces of data describing the individual seeking coverage. They use this information to determine the likelihood of a claim and its potential magnitude. After doing so they will conclude on a fair premium. Similarly, when constructing a credit spread strategy it is important to identify the prospects of incurring a loss, and knowing the extent of the damages. The first step is to determine the odds of the options expiring in–the-money. Obviously, the less likely it is to be profitable to the buyer, the more desirable it is for the seller. Traders can easily estimate the probabilities of a credit spread by calculating the delta of each option. The delta is equal to the change in the option value for each unit of change in the underlying futures contract. The delta can be considered an estimate of the chances that a particular option will expire in the money. For example, an-at-the-money option typically has a delta of 0.50. In other words there is a 50% chance that the underlying contract will be trading favorable to the option’s strike price at expiration.
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