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Optionetics Platinum provides tools that allow you to incorporate option model based probabilities in your trade evaluation. These tools allow you to rank trades using the same assumptions and principles applied to option model pricing. This article revisits a bearish scan performed in July to view the tools in action – from the initial scan to a review of returns displayed in the portfolio charts.

The September column introduced two trades generated from a scan for bearish diagonal spreads for Starbucks, Inc. (SBUX); they were identified as a Low Probability Spread and a High Probability Spread ranked using the Kelly Bet Fraction ([KBF] value for each. See “Platinum Tools: Ranking by Probability” from September 4^th, 2008 for more information.

Figure 1 provides the scan results which favors probability for profit over the risk-reward potential of the two trades. The top trade (Sep-Oct diagonal spread) is defined as the high probability trade for the remainder of this article.

Figure 1: Two Potential SBUX Put Diagonal Calendar Trades from Find Trades II Scan
click here for larger view

While ranking by probabilities is a reasonable approach, traders must still evaluate the potential risk for a spread to determine whether the profile is suitable for them. Table 1 provides some basic statistics for the two spreads, including essential trade review items such as the initial debit (max risk) and breakeven data. The position Max Risk can be increased by increasing the number of spreads established. To hold the position Max Risk to the initial debit, the diagonal spread must include a short, nearer month option and long, later month option, holding the long option through expiration of the short option. 

Table 1: High & Low Probability Spreads Distinguished (using 1 spread)

Although the breakeven level is further away from the current price of SBUX for the High Probability Spread, there is more time for things to go right or wrong for it.. Given the past movement in SBUX, the higher risk trade is also 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 of the near term option.

Both trades were opened on Friday July 25^th, with 21 spreads established for the Low Probability Spread and 24 spreads established for the High Probability Spread. This translates to an entry debit of $1,239 for the Low Probability Spread versus an entry debit of $1,968 for the High Probability Spread. Both are placed in a portfolio that starts at $50,000 and rely on an eventual bearish move for SBUX.

Figure 2 provides a price chart for SBUX starting on July 21^st and moving forward 64 days. This encompasses the expiration period for both spreads. Probability cones are also displayed starting one day after the spreads were initiated (July 28^th).

Figure 2: Daily Price Chart for SBUX from 7/21/08 through 10/17/08

Although it appears SBUX moved in a relatively narrow channel, the fluctuations for the period range from a high of 17.18 (+23%) within three weeks, to a low of 9.69 (-33%) in the last two weeks of the period.

The long puts were closed using the following approach to minimize the impact from time decay:

• Sell ½ the long puts on the Mon after expiration of the short puts
• Sell ½ of the remaining long puts on the Fri after expiration of the short puts
• Sell the remaining puts on the day of expiration for the long puts.

The net loss for the Low Probability Spread was $1,026 and the net gain for the High Probability Spread was $3,510, excluding commissions. Figure 3 provides the Portfolio Chart for the two spread portfolio and includes a dark vertical for the longer-term expiration of the Low Probability Spread. The chart reflects a brief flat period that coincides with narrow trading for SBUX the first two weeks the position is held, followed by losses for both positions as a strong bullish move occurs.

Figure 3: Portfolio Chart for Portfolio Containing Low Probability & How Probability Spread

Time was clearly a friend for the High Probability Spread. The bulk of the gains were made in October when only a small portion of the long puts remained. The main question that remains is why the selection of 21 and 24 for the two spreads? The goal was not to match maximum risk, but was a money management decision based on the probabilities. More on the money management issue in December (barring any continued technical difficulties posting).

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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