Option Trading Concepts to Help You Build a Solid Foundation

15. Obtaining Favorable Odds

There's a DIRECT relationship between risk and profit. So the more risk you take, the more you can potentially earn while the less risk you take, the less you can potentially earn.

There's an INVERSE relationship between probability and profit. This means the greater the likelihood you'll make money, the lower your potential earnings and the more you may possibly lose. That's what selling out of the money options and out of the money credit spreads is all about.

In addition, the lower the probability you'll make money, the more you can potentially earn as compared to what you may lose. That's what buying out of the money options and out of the money debit spreads is all about.

These relationships among risk, probability, and profit are mathematical laws. They are as inviolable as the law of gravity. They're also restrictive because they tell us it's impossible to "have our cake and eat it too."

Inexperienced traders sometimes "cast a blind eye" to this truth and implement strategies that have greater risk than their accounts can handle. It's vital, however, that each trader's plan balance risk relative to account size or his account is destined for eventual ruin.

Consequently, establishing high probability trades is inappropriate if the amount that may be lost is too large for account size or too large relative to potential profit. The concept of "high probability" for options traders assumes the underlying commodity will be non-trending and exhibit random price changes. If it trends or if the distribution of price changes turns out to be non-random, what appears to be a high probability of earning a profit becomes a high probability of loss!

The conclusion? In my view, it's more important to capture a real trading edge by buying options when implied volatility is low and selling options when implied volatility is high. That's what puts the odds in your favor over the long run.

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