Low Risk-High Probability Options Trading Strategies

As an options strategist at Key2Options, I am always testing models for different strategies. Low-risk / high-probability trades are a favorite for many investors.

The Key2Options platform empowers traders with institutional grade trade analytics, giving you the ability to test your trading strategies with historical options data. By backtesting your trading strategies, we can answer the question:

What if I had applied investment strategy X during period Y?

So what is low-risk / high-probability trading? As traders, we all have a different tolerance for risk. In general, low risk means we are not willing to risk more than a certain percent of our trading capital in any one trade. That percentage will be based on your risk tolerance. High probability trades are trades that have been proven statistically and have generated more wins, with an average win rate that is greater than average loss rate. With Key2Options, the edge comes from applying money management with our proprietary State Modeling^TM.

Typically, low risk trades equate to lower returns (such as bonds), while higher risk trades offer higher returns and, in turn, higher risk. Options give us the flexibility to be conservative or ultra-aggressive because we choose which option delta we purchase or sell.

Delta is one of the option Greeks you need to understand when options trading. An option delta calculates the change in the options price compared to the price change of the underlying stock. For example, if I were buying an option with a .70 delta, for every $1 move in the underlying stock, my option would move by $.70. 

If we are buying options, we can take a conservative approach and buy deep-in-the-money options with deltas greater than .70. Or perhaps we want to swing for the fences and buy options with a delta of .20. This gives us only a 20% chance of being correct...but when we are, it should be a home run. 

When looking for low-risk / high-probability trading strategies, options give us a multitude of different investment possibilities. We can be a buyer of options, a seller of options or both a buyer and seller at the same time. Based on our view of the market at any given time, we can structure a trade to give us an edge. We can choose simple strategies, like buying long calls, or more complex strategies with multiple legs, like an Iron Condor. Each strategy has its time and place.

When volatility (the degree of variation of a trading price series over time, as measured by the standard deviation of returns) is low, it’s preferable to be a buyer of options. Conversely, it’s better to be a seller of options when volatility is high.

In stock trading, time is not as important a factor as in option buying. Theoretically, you can hold on to a stock forever. As an options buyer (in other words, someone who is long option), time decay is the number one enemy for our options trades.

With the Key2Options program, we can historically look at similar markets and test which options trades create the lowest risk based on your tolerance for risk versus reward.

What’s the Real Deal?

Let’s pretend that I said, “My system had a win percentage of 90%.” Initially, you might be impressed, right? But to really analyze the results, we’d need to delve a little deeper.

That 90% win percentage might mean that I make $10 for every win...but what if it doesn’t account for the $100 lost for every loss? In that case, I’d have a system that loses $100 for every $90 it wins. 

No thank you! 

Conversely, it might not sound as impressive for me to say I have a system that only has a 30% win percentage...but it could be highly profitable with a low drawdown.

The Profit Factor

When judging a strategy, I like to look at the profit factor, which is simply how many dollars I made, divided by the dollars I lost.

For example, if I had a system that gained $1,000 and lost $500, it would have a profit factor of 2. A profit factor of less than 1 is obviously undesirable as it loses money.

Proprietary State ModelingTM

So now that we know what to look for, how do we find some low-risk / high-probability trades?

At Key2Options, we use our proprietary State Modeling^TM to help minimize risk and enter trades when probabilities are in our favor.

Each stock and index is categorized into one of eight states. States 1, 3, 5 and 7 are bullish. States 2, 4, 6, and 8 are bearish. States 1 and 8 are at the extremes.  

Proprietary State Modeling^TM gives you a detailed analysis of what state your stock is in, with information on Daily State Distribution, Average Days by State and the Average Move per State. 

The charts below are screen shots from the Key2Options program that display information about Netflix (NFLX).

We can see that Netflix averaged 65 days in State 1, our most extremely bullish state. In a State 1 condition, it gained an average of 31%.

Using this data, we can then design and implement a trading strategy to take advantage of the time and price movement. This type of detailed analysis is necessary to lower risk and achieve maximum profitability. 

Buy/Sell Indicators

Key2Options is equipped with 20 different buy/sell indicators that can be used for modeling.  You create your own buy/sell signals and give your model trade and money management parameters. You can even test different deltas to determine whether you should be buying in-the-money or out-of-the-money options.

As a general rule of thumb when buying options, the higher the delta the less risky your option trade is because it is already in the money and has a higher probability of ending profitable.

In the chart below, I have run a test on the S&P 500 index (SPX) from January 2007 to December 2014 to see how our proprietary trade filter can reduce risk and increase our probability of success. 

Running a test with a popular entry/exit system, a 10/30-day exponential moving average, we see that the system executed 30 trades with a win percentage of 43% and had a $26,106.00 profit with a 1.34 profit factor.

In this case, I used a 100% profit target. When my trade made 100%, I closed out the position. I also used a stop loss at 50%, closing out any position when my trade reached a loss of 50%. I chose a delta of 52, which means the system will look for the nearest delta to 52 when looking for a trade.

Now, after adding our proprietary State 1 filter to the exact trade plan and running the same test, let’s take a look at the results:

The Key2Options State 1 filter displays trades only when the SPX is in its most bullish state.

As a result, this reduced the amount of trades from 30 to 21 while increasing the win percentage by nearly 15%, the profit by over $30K, and the profit factor from 1.34 to 2.41.

When proprietary State Modeling^TM was used as a filter, some losing trades were rejected. It’s also important to look at the consistency of trades. No one trade makes the majority of the profits.

The Flexibility and Leverage of Options

Options are a great investment choice because of their flexibility and leverage. You can hedge a long position or use the leverage for pure speculation. In either case, we can actually reduce risk by purchasing options. Although there is risk in trading options (because let’s face it, there is even risk in keeping your money at the bank), the risk can be minimized and controlled.

The key to low-risk / high-probability trading is knowing when to trade, and understanding and quantifying your risk. 

Key2Options gives you the ability to analyze historical data and make informed decisions about your trading. Because risk is a relative statement, it lets you determine what your risk tolerance is by creating models to suit your investment objective.  When combined with our state modeling, you can find low-risk /  high-probability trades.

At Key2Options, we believe you should Plan Your Trade and Trade Your Plan!

THE SPECIAL OFFER

Learn more about becoming a Key2Options member!

Visit this page to see our different levels of membership and pick yours- www.TradingPub.com/LRHP6

About the author

Michael McNelis is an options strategist with Key2Options. He began his career working for J.W. Investment Bankers, then co-founded Hatshack, a mall-based retail chain that eventually grew to 49 stores before being acquired by the publicly traded company Genesco.   

Michael has been trading financial markets for over 20 years and has managed portfolios including equities, options and futures contracts. He has extensive use of options for income through covered call writing, hedging, and for capital appreciation, and has traded S&P, oil, natural gas, gold and U.S. dollar futures contracts.