Platinum Tools: Ranking by Probability, Part II
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September 8, 2008
Continued from Platinum Tools: Ranking by Probability, Part I (9/8/08)
Risk Graphs
Figures 2 & 3 provide Platinum Pro Risk Graph 1 (RG1) information for each trade, including the diagonal spread legs, risk-reward and breakeven data with Greeks, a risk graph with notes, and a price chart with probability cones. The price chart ends at expiration of the short contract or the current date, whichever is sooner (August 15th and August 28th, respectively). You may need to view an enlarged image to note the distinctions provided in Table 1 for the two trades.
As mentioned, the two different expiration months require the model to estimate implied volatility [IV] and the long option value after the short option expires to draw the risk graph. This also impacts breakeven calculations. Each trade has a risk that remains limited to the initial debit since the short contract expires earlier. SBUX closed at $14.42 on the day the trades were established.
Although the breakeven level is further away from the current price of SBUX and there is more time for things to go wrong in the high probability spread, there is also more time for things to go right. Given the past movement in SBUX, the higher risk trade is also calculated to be the one with a higher probability of being profitable. This isn’t the greater risk = greater reward logic. Probability of Profits does not quantify profits, it only provides statistics for the likelihood of profits at expiration for the near term option.
Figure 2: Platinum Pro Risk Graph 1 Information—SBUX High Probability Trade
Figure 3: Platinum Pro Risk Graph 1 Information—SBUX Low Probability Trade
How did things actually go for the two trades when August 2008 expiration arrived? Figures 4 and 5 provide a look at the Portfolio Chart for each trade separately, assuming a portfolio start value of $50,000 and 24 spreads for the High Probability trade and 21 spreads using the Low Probability trade. SBUX closed trading on expiration at $16.69, resulting in the short put expiring worthless for the Low Probability trade.
Figures 4 & 5: Portfolio Chart for SBUX High Probability & Low Probability Diagonal Spreads
SBUX moved counter to the longer-term bearish outlook, but consistent with the shorter-term bounce anticipated. As a result, the near month short put in the low probability trade expired worthless consistent with the goals for a diagonal put spread. However, with SBUX trading around $16 on September 3rd, the potential longer-term bearish move has yet to materialize. What’s important to note is that August at expiration, the high probability trade with 24 spreads lost less money at this first milestone than the low probability trade with 21 spreads ($624 versus $966).
As always, it needs to be re-iterated that a probability ranker won’t guarantee better results or is the “right” ranker to choose. However, focusing solely on risk-reward without considering probabilities may not get the job done for you. Ranking by probability is a good first step when considering trades that are consistent with your overall risk management plan. The number of spreads selected for each trade and the final trade results (without adjustment) will be updated next month when exploring Platinum’s Money Management tools.
For more detailed explanations on probability and Platinum tools, check out the Analytical Toolbox articles from August & September of 2006 written with John Broussard or the online Platinum Help Guide.
To access other articles written by Clare White, please click here.
Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Visit the Optionetics.com Discussion Board
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