It’s great to know how much you can make on a trade, but it may be equally beneficial to filter for trades with a low probability of experiencing the maximum possible loss.
The decision recipe for evaluating opportunity probabilities can precede an open position action and allows you to determine a position’s likelihood of profit to filter for opportunities when adding new positions. This enables you to analyze the probability a position will be profitable, in-the-money, or a max loss at expiration.
It is important to remember that this is just an estimate based on current market conditions and a normal distribution, but markets do not always behave “normally.” Still, this powerful recipe will ensure that an order only goes to the broker if the probability of maximum loss is below your predefined level.
The bot automatically factors in the credit or debit of the position, where the stock is currently trading, and how much extrinsic value, such as time until expiration and implied volatility, is priced into the option contracts.
You no longer need to monitor deltas and probabilities manually to identify trade opportunities. The bot checks a position’s probability when you precede criteria with this decision recipe in the automation editor, so you can be confident using quantifiable probabilities when building out a position.
Hi everyone. In this video, I want to show you how to estimate the probability of max loss automatically inside of your bots and automations right here at Option Alpha. And I say estimate because it is just an estimate of the probability of max loss based on current market volatility and a normal distribution graph.
So, we know that obviously normal distribution graphs are really tough to work around because markets don’t move in a perfectly normal distribution, but unfortunately, there’s no better alternative. This gives you a really good estimate and really good range of potentially where the max loss probability falls for particular positions.
Now, this is a really fun way to use this decision recipe inside any of the bots that you currently have running if you want to use max loss probability or some probability threshold as a decision factor before entering a position.
So, in this case, we have a very simple automation that we were starting to set up. We're doing some criteria and some filtering and decisions on where the stock is in a range or whatever technicals or indicators you want to use that would all go up here.
Eventually you would get to the point of entering a position; something like open a short SPY put spread. And in this case what we want to do is we want to actually check and see if the probability of max loss on this short put spread that we’re about to send over to the broker is below a certain threshold.
Whatever that threshold is for you, we can set it for the particular position. And this would ensure that the order only goes to the broker only if the threshold for this probability of max loss on the position is below some level that you set.
So, the easiest way to do this is to simply proceed the open order action with a new decision. We’re going to go up here and we’re going to add a new decision that’s going to reference one of these opportunities. Again, the opportunity is just pulling in data for a particular trade that you’re about to send over to your broker. And it’s just referencing some of the data inside of that opportunity.
In this case, we’re going to use this last recipe down here at the bottom which is the opportunity chance of profit or loss or being in the money is more or less than some value that we’ll set.
So, we simply click on it and then we have to choose what data we want the bot to reference. In this case, because we’ve already created our open position action and we’ve already built out the short put spread that we’re about to enter, the bot is smart enough to recognize and pull in that information as a recent entry.
This gives us the ability just to reuse that same opportunity that’s currently being referenced. We can double-check the figures here and the expiration and the strikes that we’re using, and once we’re good to go we simply hit save.
Now what we need to do is move over to the next field. Notice that in this simple recipe, we can check the probability of any profit potential that the stock, or that the position, might potentially have.
This again factors in the credit or debit of the position and references that against where the stock is trading currently and then how much time and volatility is baked in to the option contracts. You can also check the probability of the position just being in-the-money by expiration. So just being in the money by just one penny at expiration or the probability of max loss.
Now that’s the one we’re going to use for this particular video and training, is checking to see that the chance of max loss is less than a certain threshold that we’re going to set. Notice that when we go over here, we can set it as more than or less than. And because we want to look up the chance of max loss being less than a certain threshold then we simply go to the chance of a max loss on the position being less than some value that we set. You can set this value to anything that you want.
Again, it would probably be something similar to what the probability of losing on the trade is based on the deltas and the time until expiration or how wide the position is. But remember that this is going to pull the estimated probability of max loss, so the furthest end of your potential spread or position that would create a max loss scenario at expiration. In this case we’ll set it at some low threshold like 20%.
So, we would be willing to get into this trade if the max loss on the position has a probability of occurring less than 20% of the time. Once we’re good to go we simply hit save and we add this decision to our automation editor.
So again, what’s going to happen when we run this scanner and we’re looking for opportunities inside of our bot, our bots are going to check and see if the S&P’s price is above the 200-day moving average or any other set of criteria that you want to use. And then it’s going to check and see if the potential spread that we’re about to enter, this short put spread that’s 30 days from expiration with a 0.30 delta short strike and a 0.10 delta long strike, has a chance of max loss that is less than 20%.
If the likelihood of losing all of the max loss money on this position is less than 20% and the answer to that is yes, then I’m okay entering the position. That’s the way that it’s set up right now. Again, you can modify this and tweak this and adjust this to whatever threshold and criteria you want. Now let’s just test this to see what it would actually return using current market data right now.
One of the cool things you can do inside of your bot is just simply run a test of your automation and just verify any of these fields and see what the actual results would be if you were to turn this thing on and run it live. In this case we just tested an SPY and you can see SPY's price is above its 200-day moving average and the short put spread, the chance of max loss is in fact less than 20%.
If we want to see exactly what that probability is we can go over here and we can see that actually the probability of losing on this position right now with current market data is less than 3.21%. That’s a really low chance of losing the max loss on this position, which means it probably has a really high probability of success if it’s going that far out in time or if these spreads are pretty wide. In this case, it makes sense that it would have a really low probability of max loss.
So, if that was the criteria that I wanted to use and that was only the criteria that I wanted to use, the answer to that question would be yes. And it would continue down the path to actually opening and entering the position.
Now, if I had some other set of criteria that I want it to look at, or if I had some other threshold that I wanted to use, I could just make a simple tweak here and I could say something like less than 5% or I can say something less than 2%.
Whatever that number is for you, you can put it in there so you can let the bots do all the checking and math and calculations for you on the fly. So, once I go in here and I change this to 2%, I’m going to go ahead and run it again and we should run into an issue where it doesn’t continue down that path. And you can see once I run that automation through a test, it then stops at this decision action here and we can see that the probability is 3.17% which is above our 2% threshold that we set.
This is really great. And it’s an intelligent, smart way to start using these decisions inside of your trading and inside of your strategies that you’re running to make sure that the bots are only sending orders that would be appropriate for your risk level or risk tolerance for positions.
This is also really cool because it allows you to let these bots run continuously and whenever the criteria are in the market for a potential opportunity then the bot would execute a position. It removes the requirement that you have to be there all the time and watching positions and monitoring deltas and probabilities yourself because you really can’t do that anyway.
So hopefully this was really helpful. As always, if you have any questions let us know. And until next time, happy trading.