Welcome back to my series on using volatility to trade smarter.

Today let's evaluate something a little less volatile than Google: a call credit spread on the Spiders (Symbol SPY), the Exchange Traded Fund (ETF) based on the S&P 500 index. On January 23rd, 2006 the Spiders where trading at 126.42 and we could sell the 130/132 March expiration call credit spread for a net credit of 0.55 cents.

Sell SPY March 130 Call @ 1.10
Buy SPY March 132 Call @ 0.55

Net credit                       0.55

If we sell this spread we're hoping the market stays the same or goes down. The break-even point at expiration for the trade is the lower call strike (130) plus the credit received (0.55) or 130.55. The maximum gain is 0.55 the credit brought in, and the maximum loss is the width of the spread minus the credit received or 1.45. Armed with this information, let's check TradeKing's Probability Calculator to see what the options marketplace has to say about the chances of the ETF finishing below our break-even point at expiration.

 

After entering the symbol SPY and the March expiration date, the calculator provides us with the ATM volatility of 12.94%. Now enter our break-even point (130.55) as our first target price and the upper strike price (132) as our second target price and hit "Calculate".

The calculator instantly tells us that, based on what the marketplace is implying the future volatility of the stock to be, there's a 70.92% chance of making one penny or more on this trade. There's only a 7.1% chance of the stock finishing between the strikes. Better yet, the probability of us losing the maximum amount or of the stock going higher than the upper strike (132) is relatively low, 21.96%. We're home free, right?

Watch out: it sounds promising, but there's another way to use these chances to make the right evaluation for you. Even though the possibility of making one cent or more is 70.92%, the "Probability of Touching" says there is a 51.07% chance of the SPY will touch the break-even point sometime before the expiration date. In other words, this is a trade with a relatively high probability of success (70.92%), but also has a high probably (51.07%) that at some point the trade could become a loser. The next question is, can you handle this information and are you willing stick out the trade until the end?

Understanding volatility means you no longer have to enter into a trade and not know what the marketplace thinks of that move. I have seen many traders try to use volatility to find "bargains": the implied volatility is too high or too low. I say the option is trading at that implied volatility (or price) for a reason--embrace it and understand why.

The nice thing about understanding the math before you place trades is that it puts all stocks on the same playing field. No matter what underlying you're trading, implied volatility can help you consistently find the trade that statistically gives you the same probability of success, time and time again. Being consistent, especially in risk management,  is one of the best things you can do for your trading.

Let me know if this series helped you, if you have other ideas for similar series, if you have any war stories of your own where implied volatility played a key role. At TradeKing we're all about learning from other traders so everyone can trade smarter.

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

Hello SF,

Thanks for reading. I do think the series on volatility is one of the better series of posts in my blog. If you liked this section I think the natural progression to start reading the next series on the greeks. Here is the link to the first post in the series.

http://community.tradeking.com/members/optionsguy/blogs/2110-greeks

Regards,
Brian (Og)

Glad i am reading your postings again. Idea of looking into probabilities of touching first target and second target was an eye opener for me.

There is typo error in the sentence where you mention entering break-even point of 103.55, it should be 130.55.

Thanks Brian.