Strike Price Anchoring with Probabilities

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In this video, I want to talk about the concept of strike price anchoring. Now, previously we discussed the concept of using targeted returns or targeted probabilities here in track two as your guide post for how you should be placing trades.

Now, today I want to go through a bunch of examples in real life with my portfolio here at Option Alpha and Think Or Swim on how you can use strike price anchoring or this concept we developed here to help you place trades at the same probability level regardless of your account type or size.

This is a more advanced topic but once you master this concept you'll be able to easily maneuver the options pricing table to develop a consistent habit of entering trades and that's the whole goal here, to get you into a habit of getting into the market, placing trades on a consistent basis and doing it the right way, and using this concept of strike price anchoring is really helpful because it makes sure that you're placing trades at the same probability level each and every time.

Before we do this, though, I want to remind you that again; the market always has tradeoffs. You've probably seen this thing a bunch of times, and it's worth repeating that when you take less risk, you're profit goes down as well, or your total dollar potential profit.

When you take more risk, so when you increase your margin or increase your position size, then your potential profit goes up, so don't be stupid and assuming that there are no market tradeoffs and that there's an easy way to go about this.

The market is always efficient and is going to have tradeoffs whether you take on more risk or less risk, and it's going to reflect that in how much money you make or your profit potential.

Today what we're going to do is we're going to look at DIA which is the Dow Jones E.T.F., and it's a major market E.T.F., so it's liquid, it's got lots of liquidity, and recently it's been on a big move up and a big run-up.

Whether you think it's going higher or lower, it doesn't matter at this point, and again what we're trying to prove here is this concept of strike price anchoring. So we won't get too deep into options pricing whether the trade has good pricing or bad pricing in this video.

I want you to focus on pricing; it's just the concept of which strikes we want to be selling or not. So in this case, if we go to the trade tab here for DIA, at the time we're doing this video, the may expiration date is about 52 days out.

That's a pretty good distance depending on whether you want to sell options or buy options. It's around the 45-day mark so it is a good place that we can start selling options.

In this case with our video here today, we're going to focus mainly on option selling strategies. What I want to focus on is that usually what people have trouble with is they don't know where to start selling options depending on the strategy that they're choosing.

What we say here at Option Alpha is that you have to focus first on a probability of success level and then build everything else off of that.

For example, we focus on building all of our trades on the short premium side, so all of our option selling strategies for the 70% chance of success level, meaning that all of our trades have about a 70% chance of success or something very, very close to that.

Now from here, we can build out a bunch of different strategies and it all is going to use the same strike prices. As long as we know what targeted probability of success level we're focusing on, you want to keep that in mind and try to build out all of your trades at that same target.

So again, in today's video, because we use this here at Option Alpha and this is what I use, is build all of your trades to have a 70% chance of success.

Now let's first go through and build out a simple credit spread trade in DIA, and we'll build it out in both ends, but let's say that we are bearish on DIA, so if we go back here to the charts we're bearish on DIA, we think DIA is going to go down, so we're going to sell a call credit spread above the market at some strike price level that gives us a 70% chance of success.

The first thing that we have to do is we have to look vertically, up and down, our probability of being in the money column here on Think Or Swim, and we find the probability level that gives us about a 30% chance of losing on this trade, so in this case we could use either the 179's or the 180's but we'll look at the 180's.

You can see here that the 180 strike calls have about a 30% chance, 27.8 so I'm rounding up to 30, about a 30% chance of being in the money at expiration, which again means that there's about a 30% chance that DIA goes from where it is right now at 176 and closes above 180 between now and expiration.

So this trade has about a 71, 72% chance that it's going to be a winner. Where the chance that DIA never goes that high between now and expiration.

So if we're building out a call credit spread in DIA, this 180 strike becomes our anchor strike. This is the strike that we are going to base every strategy that we want to do, every short premium strategy in DIA around if we're doing it directionally lower, meaning directionally bearish.

So if we wanted to do, let's say, that call credit spread, we could sell the 180 strike, so in this case, we sell the 180, and we would buy the 181. So we'd go here and buy the 181 and get a credit of $36 for $1 wide spread.

This particular trade, and again we're not going to go too deep into options pricing here because we'll cover it in different videos in track number two, but in this case, we have a max profit of $36, the max risk of $64, and again, 70% chance of success.

If we wanted to, let's say, have a bigger credit, so we wanted to increase our credit in this trade above the $37 without increasing the number of contracts that we're doing, then we could widen the spread out, and instead of buying the 181 calls, we could buy the 182 or the 183 calls.

So we could widen out this spread and buy calls that are a little bit further out, so make a $3 wide spread instead of a $1 wide spread, and you can see now that our credit gets increased by almost 3X. Not exactly 3X, but almost 3X.

Now with this particular trade, we have a potential max profit of $89, the potential max risk of $211. Again, same 70% chance of success on this trade as the other trade.

It just depends on how big your portfolio is, how much risk you want to take on, how much room you have to add positions, whether you want to do two contracts $1 wide or one contract $2 wide or $3 wide.

It all really depends on what you exactly want, but again remember, the key here is that we're really not moving or touching our anchor strike price in this case, which is the 180 strikes, because that hinges on everything that we do and it keeps or maintains that 70% chance of success level.

Now again, if we wanted to, let's say, increase the number of contracts that we were doing, so we sold two contracts, and increase the width of the strikes even further to the 180 to 185, now you can see we take in, even more, money on this trade, and now when I hit confirm and send here you can see that our risk profile is a little bit different, now we make $238 versus $762 of risk, but again everything that we're doing here, because we kept that same short strike the same at 180, still has a 70% chance of success.

So hopefully this concept of strike price anchoring makes sense. We want to find that anchor strike price in everything that we do here so that we can build trades off of that. And notice we don't touch that anchor strike price of 180.

We're touching the back side of it, or the 185 strike, moving that up or down vertically. 181, 183, 185, et cetera. Now let's say that we were bullish on DIA, so now we want to go to the put side, and now we want to build a trade that makes money if DIA continues to move higher.

Again, we'd be selling options somewhere down below the market to give us about a 70% chance of success. So again, if we look vertically, up and down our probability of being in the money column here, we're going to try to find the probability that's around 30% chance of being in the money, meaning there's a 30% chance that DIA trades down from 176 to that strike price between now and expiration.

If there's only a 30% chance that it gets to 170, being as it starts at 176, that means that there's a 70% chance that it never gets to 170 or below between now and expiration.

So now our new anchor strike price becomes 170 on the put side. So again we can build out the same types of trades using that 170 as our new anchor strike price so that we could sell the 170, 169, and in this case, it takes in about $20 of premium, you can see.

So $20 of potential profit, $80 of max risk, again 70% chance of success. If we wanted to take in a little bit more premium on this trade without having to sacrifice the number of contracts, so still do one contract, we could now widen out the strikes to the 170, 166, and again you can see that gives us a credit of about $68, so now we're taking a little bit more money.

We take on a little bit more risk obviously, $332 of max potential risk, but again this position still has a 70% chance of success because we're still using that same anchor strike price of 170. So everything hinges off of this short strike at 170.

Hopefully that concept makes a lot of sense now. This concept of just finding that anchor strike price in whatever you're doing, and then building everything off of there and playing around with the strike prices to see what fits your portfolio. So this is a key differentiator in how you can build trades, because again, from this one strike price at 170, you can build trades that fit a very small portfolio.

So if you have a small portfolio, you can handle a trade that pays out $20 and has a max risk of $80. If you're portfolio can't handle $80 of risk, you probably need to save up a little bit more money.

In this case we can use that same strike price of 170, now that we know it's got about a 70% chance of success, about a 30% chance of losing, we can use that to build trades that fit our portfolio, just make them as wide as we need to, or as many different contracts as we need to, there's a bunch of different things that we can do.

So now let's take a different approach here. So now what we're going to do is we're going to play DIA neutral. So now we're going to assume that the stock is going to stay range bound, within some range, and now we want to trade both sides of the market.

It doesn't matter if you're going to do a strangle or an iron condor here, the whole key is now we've got to find the trades on each side of the market that together give us an inside probability range of 70%. Before, we were finding the one strike price on either side that gave us a 70% chance of success.

Now, we need to find the two strike prices when added together give us a 70% chance of the stock being inside some range. In this case what we're going to do is we're going to look at the 183 calls above the market, and we're going to look at the 164 puts down below the market.

Hopefully we can get that both in our screen. The reason I chose these is that if you think about it if we're looking for a 70% chance of success on the trade overall, that's going to be our inside range with a likelihood that the stock stays range bound.

What we need to do is we need to find the probabilities on each side that are around 15%, if we're going to do this trade completely neutral.

In this case, the probabilities that are closest to 15% on each side are the 183 calls, that becomes our strike price anchor on the top side, and the 164 puts, again that becomes our strike price anchor on the bottom side. This is for a neutral trade, so this is how we find these anchor strike prices on neutral trade.

Together, the probability that the stock is either below 164, so down here, below 164, or above 183, so above this price, is about 30.8%.

All we did has we added together the probability of being in the money or the probability of the stock being below 164, and we added that probability to the probability of the stock being above 183, and we get together about a 30% chance that it's either above or below these two numbers.

I'll say it again, we added together the probability of the stock being in the money on each end, and that gave us a total probability of losing on this trade, meaning we only lose if the stock is above 183 or below 164, of 30.8%.

So if the probability of the stock being outside of these two ranges is 30%, then the likelihood that it's inside these two ranges is about 70%. So now, with these strike price anchors, we can determine that as long as we use our short strikes set at 183 and 164 for DIA, we've got about a 70% chance of success on anything that we do with those strike price anchors.

Notice, I think it's really important here that the strike price on the put side is much further away from the market than the strike price on the call side. The reason that is, is because the market naturally has a little bit of bearish ski right now, which means that people are pricing in a little bit of a move lower, or an expected move lower.

As long as you stick to that 70% chance of success level, you're option pricing and the option market is naturally going to move and adjust these prices and strike prices to compensate for market skew and market risk.

If the market is assuming that the stocks might fall a little bit or pricing in a little bit of a fall, then it will naturally skew the strike prices, and as long as you focus on this anchor strike price methodology, you're going to be fine.

In this case we have the 164's and the 183's, so if we go back to the chart here of DIA, it means the 183's are right about here, on D.I.A., and the 164's are all the way down here.

Again, notice that the options market is naturally giving stocks a little bit more room to move based on the current run that it's had, and that seems logical. That's a pretty big run, so it only seems natural that it could move over just a little bit more or kind of trade just a little bit lower.

Again, this range is our 70% chance of success range. There's a 70% chance that the market stays between these two strikes. There was about a 17% chance that the market was below this level, and there was about a 13% chance that the market was above this level up here.

Again, all we did has we added those two probabilities together, and that's how we determined out 70% anchor strike price. So now from here we can go ahead and sell the 164, 183 strangle around the market.

If we did that and just did it naked we'd take in a credit of 152. The margin that would be required on this trade is $2,829, so obviously, we're taking in a bit more risk. We're putting up a little bit more money, but we could potentially make up to $152 for each of these contracts.

If we wanted to build out an iron condor, we could again use those same anchor strike prices and then just buy options on either end.

So let's say we sold the 164's like we did before on the put side, and we bought the 162's and then on the call side we still sold the 183 calls, and we bought the 185 calls. Now we have an iron condor going in DIA, and now you can see that our credit has been reduced down to $48, but our risk also has been reduced down to $151.

So it all works the same. Both trades have a 70% chance of success. One trade obviously you put up a little bit more margin and capital, you make a little bit more money.

In this case, you could do more contracts on the iron condor, and make about the same amount of money as you make with the short strangle. Again, it's just this concept of using this strike price anchoring to determine that 70% success level, and then basing everything off of that.

Again, if we at Option Alpha were to send out an alert for a strangle, and we did the strangle in DIA, you could then come back in and do the iron condor if you wanted to keep your risk capped at about $150.

You could use the same short strikes that we used on our trade, which we would use the 183 calls and the 164 puts, you use those same strikes as your strike price anchors to now build out this iron condor that gives you about the same probability of success, you're just only going to sacrifice your potential profit and max loss are going to be a little different because now you're doing it risk defined.

Again, you can widen out these strikes as much as possible, or make them narrow, but the only thing that you don't want to do is you don't want want to move those inside short legs of 183 and 164 on the put side because those are your anchors. Those are what give you that 70% chance of success that you're looking for.

Another concept that I want to cover here in this video is that we can skew trades in any direction now, now that we have this understanding that we can use these strike price anchors to determine the same probability of success level, whether we're doing it a bearish trade, a bullish trade, or a neutral trade.

Now we can skew trades and still maintain a 70% chance or success. Let's do something a little bit different here. Let's assume that we think that the market is going to float mostly higher.

So from here, and again this is just an assumption, that we think the market is going to float mostly higher. But we still want to have a neutral trade on, so we don't just want to go purely bullish on DIA, we want to have a neutral trade, but we want to skew that trade a little bit higher.

For example, if we had originally the trade that we were looking at before, which was totally neutral probability wise, was the 183 calls and the 164 puts.

Well what if we now did something where we sold the 168 puts down below the market, because we don't think that the market's going to fall that far to 164, but we think it could fall as low as 168.

Now we want to move up those put strikes to 164. We also want to move up the call strikes likewise to some level above 183 so that we still maintain that 70% chance of success.

Now we've just moved our profit range up just a little bit more, or our targeted range up just a little bit more. Again, we can still make a directional to neutral trade in DIA with the same high probability success level.

So here's the deal. If we were to sell the 168's, just to use that example that we had before, if we sold the 168's on the put side, if we thought, "You know what, the market probably can't go as low as 168," we now know that the probability of the market getting there and closing below that level is 25%.

So if we think about it, our 70% chance of success trade must have a 30% chance of losing on both sides. Well right now on just one side of the trade, if we're going to make this thing neutral, we've got a 25% chance of losing.

So now we need to find the trade on the top side of the market that has just a 5% chance of losing, so that together, if we add this trade, the 168's and the trade on the top side of the market that has a 5% chance of losing, we get a 30% chance of being a loser on this trade, or still a 70% chance of success.

Here you can see this is probably the strike price that we would target, is the 186 calls above the market. Those have about a 5% chance of being in the money. Again, if we add these two strikes together, or the probability of losing on both of these strikes, the 25 plus the 4, then we get a 30% chance of losing on this trade.

Now our profit range has just shift higher. Now you can see that our potential profit range has shifted just a little bit higher. Originally we were at the 183's on the call side; we've now moved those up to the 186.

Down below the market we were at the 164 strikes on the put side, we've now moved those up to the 168 strikes on the put side. Same probability of success, you're still targeting that same 70% chance of success level, but now you're just shifting or moving your strike prices to be a little bit skewed higher.

Again, you can skew it as much as you want, or not; it doesn't matter. Sometimes we'll come in and skew trades a little bit, but most of the time we just usually stick to that 70% level regardless of where the market is because we don't necessarily always have an opinion on the market, we just want to make money at our 70% level that we target all the time.

So that's the concept that I wanted to introduce to you today is this strike price anchoring. Before we go I want you to realize that if you don't have Think Or Swim, this is a really important concept that I probably should have mentioned earlier but I'm sorry if I didn't, you can use Delta as an approximate for these probability levels.

What you want to realize is that if you don't have Think Or Swim, you can't calculate these probability levels. We also have them on our watch list so that you can use the watch list as a good proxy for this as well. Then what you can do is you can use Delta as an approximate for the probability of losing on a trade.

For example here, if you look at the 180 call strikes that we looked at before, the actual hard probability which is probably more accurate than Delta is .2741, so that's the probability that we'd lose on this trade.

The Delta, in that case, is about 29. So you can see that the Delta at 29 is basically as a .27 probability. There's going to be a little bit of difference, and again it's always going to be used as an approximate, but it's going to be pretty close. It's going to be within a couple of points here.

The same thing goes here at the 183 call strikes. You can see the actual probability of losing is 13.57, so basically .1357. The actual Delta is .14, so again very similar.

So if you don't have probability of being in the money, then you want to try to add up these Deltas on either side so that your total Deltas are about .3, and again that's if you're targeting the 70% chance of success level on all of your trades, or if you want your trades to win out at about 70% of the time. You want to target total Deltas of .3.

It's going to be a little bit different because, on the put side, you can see Deltas are negative, and then we don't care about the negative aspect of Delta when looking at probability because, again, the same concept makes sense.

You just want to say, "You know, okay, look. This is a .24 Delta here basically. I know it's negative, and that's just from option pricing and how option prices move," but probability-wise you still want to look at it as a .24 probability which is very similar to a 25% probability of losing.

Same thing if we looked up here at the 171 put options. You can see those have about a 34% chance of losing or about a .34 chance of losing. The Delta is .32. Again, negative only for option pricing, meaning they lose money if the stock goes up, but again we just want to add up these two sides to get to 30.

Again, you forget about the negative aspect of this; you're just adding up the raw Delta .32 or .29 or whatever the case is.

Again, if we were going to build out a trade that had 70% chance of success, and we were only looking at Deltas and we wanted to build something that was neutral, what we'd basically be doing is building out a trade that was somewhere around the 183's like we did before, and the 164's.

So again, if we were only looking at Deltas, we want total Deltas to add up to about 30 on a raw, kind of positive basis. You can see we get 16 Deltas here, so.16, again for the last time we're not looking at the negative side, we're just looking at the raw Deltas here.

So .16 plus .14 is the Delta on the call side, and that gives us about a .3 total Delta, which means about 30% chance of being in the money on either end.

Ironically, this is the same probability levels that we focused on earlier. This is exactly how it works. You don't need this probability of being in the money levels; you can use Delta as your approximate.

You're just going to work towards a.30 Delta, or a 30% chance of success level. Whatever works for your broker platform. Hopefully, that makes sense. If you have any comments or questions, please ask them right below in the video box.

I want to make sure that we get everything squared away here because this is an important concept of continuing to focus on that same probability of success level, it's really important.

Again, just one last time, most of the pricing that we have seen and found is that somewhere around the one standard deviation level, or the 70% chance of success overall, gives us the most optimal use of capital risk reward wise.

We've covered this in other videos, again that's where we focus most of our trading. We feel like 60% winners is not enough, we feel like 80% winners might be too much where we don't make enough money on those trades.

We've always found that making trades around the 70% probability level ends up being a good use of capital and risk reward trade.

As always, hope you guys enjoy these videos. If you have any comments or questions, like I said, ask them right below. If you loved this video, please share it online. Help spread the word about what we're trying to do here at Option Alpha, and until next time, happy trading.