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A popular option strategy is the short strangle, which consists of selling an out of the money put and call. My personal backtesting and real trading experience is that this strategy on equity market ETF's or cash settled indices can increase portfolio diversification and if overlaid on a portfolio of underlying assets like mutual funds or ETF's can also increase total returns. When you sell a strangle, you bring cash into your account. By doing so, you can "overlay" this trade on top of a portfolio consisting of ETF's or other investments without paying margin interest. Before we get too deep into the weeds, lets deal with the elephant in the room...you've heard strangles are risky. Is that true? The answer isn't that simple, as the trade isn't what measures risk, instead, it's the position size. Excessive leverage is risky, but strangles don't have to be traded this way. I'd encourage every option trader to not only consider the margin requirement of any particular option trade, but the notional risk. For example, think in terms of a 1 contract SPY strangle with SPY trading at $280 as theoretically being a $28,000 position (stock price X 100), similar to how buying 100 shares of SPY at $280 is a $28,000 position. When sized this way, a typical strangle will actual have less risk than the underlying asset. With this in mind, let's look at a rough example of how we could implement this idea in a $100,000 account. First, we'll look at the performance of a 50/50 stock/bond portfolio that is rebalanced monthly since 2000. This portfolio would have returned a little over 5% annually, with a standard deviation of 7.31%, producing a Sharpe Ratio of 0.54. Next, we'll add a 50% strangle allocation to this same portfolio. Yes, this equals 150%, which does make this concept only possible in a taxable margin account. The strangle allocation is based on our own backtesting platforms and proprietary rule sets and includes hypothetical trades on both SPY and IWM. A trader would sell 2 strangles on SPY in a $100,000 account to approximately replicate the concept. Blue: Stock/Bond Portfolio Red: Stock/Bond/Strangle Portfolio The 50/50/50 portfolio nearly doubles the annualized return to over 10%, and only with a modest increase in standard deviation to 8.37%. This increase in risk adjusted return substantially improves the portfolio Sharpe Ratio to 1.05. Even with a 50% increase in total portfolio allocation, the portfolio risk only slightly increases due to the low correlation of the strangle strategy to both stocks and bonds. This example is only meant to show the concept of an option overlay in action, and the potential benefits of doing so. Many other creative ideas could be implemented with other underlying assets and option strategies. My investment advisory firm, Lorintine Capital, currently implements these concepts in managed accounts as well as in one of our private funds, LC Diversified Fund. We are happy to have discussions with investors interested in a professionally managed solution, or ideas on how to implement this concept on their own. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.

It’s a popular trade because it has a high win rate. And our lizard brains love consistency… But if you’re willing to go against your innate biological wiring it’s possible to make a good chunk of change by doing the opposite. At Macro Ops we like to identify opportunities to buy deep out-of-the-money (DOTM) options. As long as the winners earn multiples of the losers it’s possible to walk away with a profit — despite the low win-rate. To win as a buyer you must carefully select DOTM options that have the best chance of upsetting the implied distribution of the Black-Scholes pricing model. Black-Scholes for the most part works pretty well. But it has a flaw, the model assumes that momentum doesn’t exist. This assumption holds up just fine in the short-term. But it breaks down badly in the long-term. As market practitioners we know that momentum, of course, does exist. And we know also that momentum becomes even more pronounced the longer the time-frame. So there’s a profitable trading opportunity if we buy DOTM options with many days left to expiry and allow the underlying enough time to drift pass the strike price. Jim Leitner — one of the most successful global macro traders of all time picked up on this long ago. He talks about the mispricing of long-dated options in his 2006 interview with Steven Drobny (emphasis mine). Longer-dated options are priced expensively versus future daily volatility, but cheaply versus the drift in the future spot price. We need to make a distinction between volatility and the future drift of the currency. Since the option’s seller (the investment bank) hedges its position daily, it makes money selling options. Since some buyers do not delta hedge but instead allow the spot to drift away from the strike, they make money on the underlying trend move in the currency. So both the seller of the option and the buyer make money. The profit for the seller comes from extracting the risk premia in the daily volatility, and for the buyer it comes from the fact that currency markets tend to exhibit trending behavior. If the option maturity is long enough, trend can take us far enough away from the strike that it’s okay to overpay. Although his specific observation has to do with the forex markets. The same logic can be carried over to the equity markets — where our DOTM (deep out of the money) strategy focuses. Hot stocks have a tendency to drift (ie, trend) for long periods. They don’t follow a random walk as the Black-Scholes model assumes. Knowing this, our go-to DOTM option strategy is to buy low delta calls 4-12 months out in time on high momentum stocks. A momentum stock can cause DOTM calls to appreciate as much as 64x of the original price…Here’s an example of that from one of our stock picks from the summer of 2017. In August of 2017 we became interested in Interactive Brokers for fundamental and technical reasons. At the time IBKR traded for $40.54. The December DOTM call options struck at $47 were trading for just $0.20. By December 15th, IBKR was trading for $60.40. A 49% gain in a few months. But take a look at the price of the 47 DOTM calls. Those were trading for $13.00 That’s a 6400% return in a few months. A $1,000 position in this DOTM option would have turned into $65,000 in just four months.... The Black-Scholes model massively mispriced these calls. A return of that magnitude should rarely occur. But we see it happen again and again in the long-dated DOTM calls of high momentum stocks. Here’s another more recent example from DOTM calls in Twitter. Twitter started to run out of its base at the beginning of 2018. By summer stockholders had been rewarded with a nice 77% gain. But check out the June DOTM calls on January 12th, the day of the breakout in Twitter. These 37 calls were trading for $0.50. By summer those same calls were trading for $8.80! That’s an incredible 1600% return. A $1,000 position in this option turned into $16,600 in only 5-months. Since Taleb’s Black Swan was first published just months before the GFC, traders have been mindlessly buying put options in the hopes that another “left tail” event is around the corner. But it’s been the wrong strategy. Since 2008 all of the outlier returns have actually occurred in the right tail. Here is yet another example of an extreme right tail return out of NFLX in the DOTM calls. NFLX had DOTM call options trading on July 7th 2017 for $0.93. At expiry on June 15th 2018, these DOTM calls were trading for $141.00…See ‘em on the option chain below. That’s about a 15,000% return. 10 contracts would of cost $930 and in one year’s time they could have been sold for $141,000... DOTM calls on momentum stocks are producing once-in-a-decade returns every year. Returns of this magnitude shouldn’t happen this frequently. But they do because the Black-Scholes model isn’t equipped to properly value DOTM call options on high momentum names. The key to executing this strategy successfully relies on finding strong, high-momentum stocks that can trend well past the strike prices of the DTOM calls. If you buy DOTM calls on the wrong underlying, like an equity index or a commodity, you’ll just rack up losses and the winners won’t be big enough to make up for it. This strategy only wins because of the magnitude of the winning trades. It’s all about realizing that right tail return and ringing the register on a 50 bagger. Focusing only on individual stocks with the following characteristics has helped us identify the best candidates for DOTM call buying. 1) The stock must have positive momentum Stocks that have been performing well in the recent past have the highest probability of continuing perform well into the future. You can run a momentum screen and find what stocks have the best 6-month and 12-month returns. Focus on those. What’s even better is if the stock is also in a sector that has been outperforming the broad market. So narrow the scan down to the strongest stocks in the strongest sectors. Finally, if you look at the chart and see a clear break higher from a congestion zone, that’s an added bonus. Breakouts from consolidations act as technical catalysts that propel a stock higher and none of the trend is yet priced into the options. 2) The company must have exciting fundamentals It’s not enough to simply scan for positive price momentum. The fundamentals should support higher prices as well. From a fundamental perspective we like to see growth potential that can exceed the market’s current expectations. The sweet trends of the FAANG stocks occurred because market participants vastly underestimated their growth potential. Usually, these high momentum stocks will have strong rates of revenue and free cash flow growth. If you see negative numbers for either of these skip the stock and go onto the next one. Finally, a strong fundamental catalyst that the market is fixated on helps to keep the hype train moving and the trend rocketing higher. Something like a large earnings beat or a new product launch is always good. 3) Attractive options After finding a quality momentum candidate we do a quick check on the listed options.Two things matter here, the implied volatility and the liquidity. Implied volatility isn’t hugely important for this strategy, our focus is betting on direction. But it’s still worth paying attention to. High implied volatility makes it tougher for the stock to exceed the strike price of the DOTM call option. In the graph below, notice how the red line (high IV) is higher than the blue line (low IV). If the IV gets too high, the cone widens so much that even a strong trend in the underlying stock can’t breach the strike price of our DOTM calls. We’ve found the sweet spot for IV is anything lower than 40%. Below 40% keeps the option strike close enough to the stock so that it has a realistic chance of outperforming the implied move of the Black-Scholes model. After IV we check liquidity conditions. The stock has to have tradable options both far out in time and far away from the strike price. The call options need at least 100 days of expiry let in them and a delta of 15 or less. You can see in the example below that IBKR is trading for $64.46. The options of interest are the ones with a strike price far away from $64.46. The red rectangle shows DOTM calls struck at $85 and $90. Also notice that these DOTM calls are much cheaper than the ones closer to the current stock price. The 90 call in this example trades for $.80. The 65 call trades for $5.60 — 7 times more expensive. DOTM calls have more positive asymmetry versus the ones that are closer to the money. Finally, if the bid ask spread looks reasonable then we’ll pull the trigger on the DOTM call. From there it’s all about letting Mr. Market do it’s work. In our experience, when it comes to managing a DOTM trade, less is more. We like to run our DOTM calls to expiry without management and just accept whatever the market chooses to give us. Most of the time that’s a goose egg — remember, this is a very low win rate strategy. But, every once in awhile we’ll get a 50-bagger that pays for all of our losses and much much more. There you have it! That’s the DOTM call strategy in a nutshell. This is one of many strategies that we implement in the Macro Ops Portfolio. If you would like even more information on our DOTM call strategy you can learn more by downloading this free DOTM guide by clicking here. Tyler Kling is the co-founder of Macro Ops, a trading community focused on the art of global macro. He is a former trade desk manager at a $100+ million family office where he oversaw multiple traders and created quantitative trading strategies for options and futures. Tyler also worked as a consultant to the family's in-house fund of funds in the areas of portfolio manager evaluation and capital allocation. He holds a Certificate In Quantitative Finance from the Fitch Learning Center in London, England where he studied under famous quants such as Paul Wilmott.

Unfortunately, when it comes to options, all too many traders are led astray on the role probabilities play in option trading and end up limiting their chances of success. This article has two objectives: Discuss Probabilities and Option Trading Offer suggestions on making winning option trades Probabilities and Outcomes Most people believe that when placing a bet with multiple choices it is wisest to take the one with the highest probability. We see this frequently when option traders espouse selling Deep-Out-of-The-Money (DOTM) calls or puts and other strategies as “High-Probability” trades. This is facilitated as most every Broker-Dealer includes “probability” as part of their option trading platforms. One requires no special math skills to determine which of many options trades offer the highest probability. Option probabilities can be just a mouse-click away. But the real question is “Does knowing the option probability help us?” Expected Return When placing bets, or investing, it is NOT the probability of outcome that dictates choice … it is the probability of outcome weighed against the “pay-off” that matters. One cannot make a successful and informed choice until one is given the “pay-off”. It is NOT probability that matters ... it is EXPECTED RETURN that matters. If you take nothing else from this article, take this… When placing a bet, one does not choose the most “probable” outcome; one must choose the most “favorable” outcome. Let’s look at the simple coin toss to better understand this. We all know that a fair coin toss has a 50% probability of landing either heads or tails. But what if the odds for winning bets on heads were one-for-one (1:1) while the odds for winning bets on tails was only 0.75:1? Though the probability remains the same, the expected return does not. One can expect to break even betting on heads and lose money betting on tails. One must not just look at the probability of “winning” but compare it to the reward to determine if it is favorable. So, what do coin tosses have to do with option trading? Very simple … option pricing is 100% about probabilities. The real difference between options and a coin toss is that expected return is not as easy to calculate. There are numerous possible results. For instance selling a DOTM Call has a fixed return on the profit side, but many possible results on the loss side…including (theoretically) unlimited loss. In order to calculate the expected return one cannot just multiply the probability by the premium credit. One must also calculate the expected loss return for each strike interval that ends up in-the-money (ITM). It means taking every possible strike for the underlying, calculating the probability associated with that strike, multiplying each strike by its probability, adding them all together and subtracting them from the probability of gain. This is an arduous task (fortunately made easier through calculus). The Greeks Consider that the Market makers determine the pricing using very sophisticated statistics and “Greeks”. Most traders are aware of some of the first order Greeks such as Delta, Theta and Gamma … but there are second and third order Greeks most traders never heard of… such as “Charm” and “Speed”. So don’t fool yourself, without advanced training in math, statistics, probabilities and the proper algorithm you cannot properly assess all the factors taken into account in the pricing. I’ll save everyone a great deal of effort in making these complex calculations and simply state that every option is probabilistically equivalent. Over time, one has NO better probability of a GROSS profit on a DOTM option than a DITM option. This may take a little explaining. Surely, a call that is written 2% DOTM has a much better chance of not being over-run than a call 1% OTM. However, it also has a much lower premium credit. Over time, the extra “over-run” risk of the 1% OTM is compensated for by the extra premium credit gained when it is not over-run. They are probabilistically equivalent. If I may “hammer this home” by using a Roulette wheel as an example. Bettors can make the equivalent of a DOTM bet by betting on odd, even, red or black. Or they could make the equivalent of an ATM bet by betting on a single number, such as 28. Over time the monetary results will be the same. They will “hit” more often on the red/black/odd/even but will win less when they do. I won’t go into it here, but the “house edge” is the same 5.26% on every bet one can make (actually, there is one bet that increases the “house edge” to 8%, but few make that bet). Let me also clear up a common misconception about probability and the Roulette wheel. Probability theory DOES NOT predict that everyone will be a loser if they play often enough. Quite the opposite. Even in a game that is purely chance and requires no skill, there will be lifetime winners and lifetime losers. It’s only when these two sets of betters are aggregated will we see the expected result. Probability theory only predicts that, over time, the winners and losers will even out and winners will win 5.26% less than “fair” and losers will lose 5.26% more than “fair”. If you are not a member yet, you can join our forum discussions for answers to all your options questions. The House Edge With this basic understanding of options probability and expected return, let’s look to see if the “high-probability” option trade is, in fact, the “most favorable” trade. To make this analysis we must add in the costs of the trade. We need to move out of theory and into reality … a reality where the Market Maker insists on a “house edge”. Before I get started, let me say that there are, on occasion, mispriced options. If there is a mispricing it can be exploited. However, this is very rare and most traders aren’t equipped to notice it. So let’s leave that on the shelf and move forward. Let me use options on SPDR S&P500 ETF (SPY) as my example. I choose this underlying as they are widely traded, liquid and have a very low bid-ask spread. Let’s look at selling a call option. We can compare an At-The-Money (ATM) trade with a DOTM trade. We must remember that the pay-offs are adjusted according to their probability. From a risk/reward perspective on a GROSS return they are equivalent. Let’s look at the bid/ask of the ATM and the OTM option. Though the bid/ask will vary dependent upon duration (weekly, monthly, etc.) …. for these purposes let’s look a month ahead. Most typically, the option will be priced as follows: Strike Bid Ask Spread “House Edge” 214 (ATM) 4.04 4.05 .01 .25% 218 (2%OTM) 1.78 1.79 .01 .56% 222 (4%DOTM) .46 .47 .01 2.12% What we discover is that the bid-ask spread (the “house edge”) when represented as a percent of the premium, actually increases the further OTM one goes. Though the options probability/payoff is theoretically identical, the “house edge” is not. So, the further OTM one goes, the less “favorable” the option becomes. If one added the fixed trading costs … which vary by broker ($6.95,$7.95,$8.95, etc.) … it would further compound the disadvantage of OTM options. As a function of the “house edge” increasing the further OTM one goes, a nearly “fair” ATM option becomes an unfavorable DOTM option. The results can be even more dramatic with many other underlying stocks that don’t have as low a bid-ask spread as SPY. For instance, many stocks have a bid-ask spread of 5cents or 10cents (sometimes even more). That means the “house edge” can be from 6% to 15%. That’s a pretty steep hurdle to jump for profitable trading. Option Spreads Often traders will enter spreads as opposed to singular trades. The theory is to limit downside by reducing costs or exposure. One must consider that every option incurs its own “house edge”. So the more legs one enters, the less likely they will have a favorable outcome. This is a hard concept for option traders to get their hands around. So let me go back to the “probability laboratory” … the Roulette wheel. Each bet theoretically loses 5.26%. So, if one bets on, say, two numbers instead of one number, they increase their chances of a “hit” but they decrease their overall chances of winning money. Inasmuch as option pricing is neutral (except for the “house edge”) over time, one gains nothing by engaging in multiple legged option strategies. Winning Option Strategies Now, let me be perfectly clear. I’m not suggesting that one cannot make profitable option trades. Nor am I suggesting that limiting costs or risk through spreads and other actions is wrong. What I’m saying is that trying to make profit by looking at option trades that are, high probability is not a winning strategy. It is not “probability” that is important it is “expected return” that is important. What we’ve discussed so far is that option trades are “odds against”. That is, they may be high or low probability but the only favorable trade lies with the market maker. Does that mean I can’t win trading options? Of course not … many people do very well and since you’re on this site, you’re probably one of them. The one thing that separates option trading from the roulette wheel is that the Roulette wheel is a game of CHANCE and option trading can be a game of SKILL. But let me be as clear as I can. The skill is NOT evidenced in “fancy-dancy” option strategies. The skill is evidenced in correctly predicting the movement of the underlying security. This bears repeating ... so here goes …. The skill is NOT evidenced in “fancy-dancy” option strategies. The skill is evidenced in correctly predicting the movement of the underlying security. Successful option traders are successful because they spend most of their time understanding the stock or the market. Let me give an example: If I said that that SPY would end up at $218 on December 31st and asked for an option strategy to match that result … option traders could easily maximize a variety of strategies. Instead, if I said that SPY would end up between $200 and $218, completely different strategies would unfold. If SPY actually landed at $218, none of these would show the gains of the first hypothesis. In contrast, if SPY ended at $200 they would all show better results than the first hypothesis. Therefore, the viability of any strategy is dependent upon its relevance to the underlying. If one gets the underlying right, they will prosper. If they don’t, they won’t. Summary Successful long term option trading starts with an understanding that there is no such thing as a free lunch. Option trades involve counter-parties and there are winners and losers on every trade. That is, except for the Market Makers taking their “house edge”. It is important to understand that options are not some sort of Magic Elixir. They are not a substitute for stock market research. What they can provide is a very calculated methodology to exploit stock market movement. It doesn’t really matter if a stock is up, down or flat … there’s an option play to exploit every possible scenario. When option traders focus more on the characteristics of the underlying and less on the characteristics of a particular option strategy, they will find it much easier to pick the winning option strategy. Related articles: Is Your Risk Worth The Reward? 10 Options Trading Myths Debunked Can you double your account every six months? Debunking Options Guru Advice Why Winning Ratio Means Nothing Do 80% Of Options Expire Worthless? Want to see how we handle risk? Start your free trial