Probability-Based Trading is very simple to execute. I am constantly challenged by fellow traders about its simplicity. “If it is this easy to execute, how can it possibly work”. They find it impossible to believe that I don’t use charts, indicators, support or resistance areas, Fibonacci retracements and Fibonacci extensions, etc. But, I must admit to the reader that it was extremely difficult to throw out over twenty years of studying so many methodologies, indicators, and systems. And when I considered the enormous investment in money and time, it was even more challenging to just “chuck” it all.
Having become consistent trading the probabilities that are right in front of me has totally changed my outlook, my expectations and my results. After embracing Probability-Based Trading, refining your strategies, trade executions and proving the concept to yourself, I trust you will not look back. Here are the steps that I take to put the odds in my favor:
1. Assemble a list of the stocks and ETFs that have high liquidity and tight bid/ask spreads.
This one step alone will free you to focus on trade strategy and executions. Like so many of my clients, I used to spend an inordinate amount of time doing all kinds of scans to find what underlying(s) present an opportunity for potential trades. I regularly talk with other traders that are consumed by trying to come up with the perfect scan or an aberration in option value. Forget it! Don’t waste time and energy trying to find trades when a good universe of 50 to 150 symbols will give you all the trading opportunities you need. With this short vetted list, I am sure you will find more trades than the amount of capital you want to put to work. I have provided a list of the stocks and ETFs that I have in my database under the “Trading Resources” page. Start with this list. This is all you need.
2. Sort your list by Implied Volatility Rank (IVR).Don’t confuse the Implied Volatility Rank with Implied Volatility and/or Historical Volatility. Most option trading platforms offer the ability to upload a database. I load my list of underlying symbols on my trading platform. I sort that list by implied volatility rank from high to low.
3. Evaluate the list for potential tradesAfter sorting the list, the symbols with the highest Implied Volatility Rank are at the top. I am only interested in underlying stocks and ETFs that have an IVR of 30 or higher for short premium opportunities. A very high percentage of the trades I take are short premium trades.
If I choose to take a directional trade, I will do long premium trades on stocks and ETFs that have an IVR below 25.
4. Quickly find potential trades that meet my criteria.
After the ranking process, I will evaluate potential trades, beginning with those having the highest rank. I enter each symbol I consider that has an IVR over 50 on my options platform. Now simply looking at the options chain, I am looking for trades that fall around the 70% probability of success range.The 70% probability of success is my “wheelhouse”. Many traders prefer higher risk and higher reward, while others like lower risk with lower returns. Each trader has to find his or her comfort area. Then remain consistent in your selection and execution to allow the odds to work for you.
5. Confirm that there is not an imminent binary event (like earnings) and route the trade.
Prior to placing the trade, I want to confirm that there are not any material binary events in the expiration cycle in which I am trading. While ex-dividend dates can have a minor impact on the stock or ETF, an upcoming earnings release on a stock can generate wild swings in the price action. Even if my exit plan is prior to the earnings release date, I still expect a gradual increase in the implied volatility and resulting IVR. On short premium trades, I am looking for volatility contraction, not an increase, so best to pass on those until the earnings are out.
By following my trading criteria, once I am filled on the trade, it is on my terms and with the odds in my favor of a winning trade of 70% or more.
6. Rinse and repeat.
The key to successful Probability-Based Trading is to trade many trades and keep the size of the positions small. This is simply putting the Law of Large numbers to work. By following the Probability-Based trade management criteria, your results will become consistent with the probabilistic expectations.
7. Manage winners.
Contrary to everything that they taught me (translate “pounded into my head”) I manage my winners and I use the Probability-Based trade management criteria to deal with trades that don’t go in my favor.
You must accept the risk at entry because that is the only time throughout the course of the trade where you have control. Simply execute the trade and let the time and strategy work in your favor.
There is compelling research and my experience has proven that it is materially more beneficial to manage winners as opposed to letting the trades go to expiration. Most traders, including me in the past, are so seduced by letting trades expire worthless. Managing trades with mechanical, non-emotional, criteria yields far better results.