14 Jan Constraining Chaos – Part Two
In my first article, Constraining Chaos - Part One, I discussed how seemingly random events can be classified in terms of "regular" occurrences and "irregular" occurrences. In other words, there are events which have a high probability of happening and there are events that are not likely to happen very often.
If we extend this idea to stock prices - or more specifically, option strike prices - we get an understanding of why option strike prices that are further out-of-the- money, are cheaper than those at-the-money, or even in-the-money.
Luckily for us, most option software calculates the probability of certain out-of-the-money strikes expiring worthless. Based on what the option market thinks, these particular strike prices, which I've highlighted below, have a 80-90% chance of expiring out of the money - worthless. What this means is that the trader who buys these options are spending a little bit of money for a large reward, but has only a 10-20% chance of success. On the flip-side however, the trader who sells these options has a 80-90% chance of success, collecting a little bit of money each time, with a 10-20% percent chance of a disaster.
(click to enlarge)
"Ok, but prices are moving all the time!! If I sell these out-of-the-money options and price starts to move against me, what do I do to mitigate my losses???"
You have to actively make adjustments to your position in order to always remain out in those 80-90% success rates. While it sounds difficult to make adjustments quickly on the fly while price is moving for or against you, it becomes easier when you have a set of rules in place and a set-number of strategies.
I've narrowed these down to 4 distinct strategies:
1. The Split
2. The Swap
3. The Double Down
4. The Roll Out
.........stay tuned for my next post when I go into detail on how to use each of these strategies.