How to Trade With Better Than 50/50 Odds

These option trades are rare, but they do exist

Mark Sebastian is the creator of the Option Pit blog.

When does a 50/50 bet not have even odds? If your answer is any betting game in Las Vegas, you are right. In the casino, the odds favor the house. If you can find a bet in Las Vegas (or Atlantic City or Macau) that pays better than even odds take this advice: Don’t tell anyone, and play that game small as often as you can until you are rich. 

In the option trading world, these types of trades are also few and far between. Like gambling in a casino, if you find a stock or options trade that pays better than 50/50 odds, keep it to yourself, trade small over and over until you are rich, according to most options trading information.

While these types of true arbitrage trades almost never happen, sometimes there are opportunities to put on trades that seem to have better than 50/50 odds. This is because options are multi-dimensional. When purchasing an outright call or put, the trader is making a bet that the market (or stock) is going to move in the preferred direction AND that the implied volatility (IV) will hold stable or increase. The same holds true for shorting options.

We are currently in a cycle that has the implied volatility of S&P 500 (SPX) options falling. This makes sense considering realized volatility is very low as well. Does this mean that owning options is a bad idea? Sometimes, YES! However, there are moments where it can make a ton of sense to buy options. On Nov. 24, the day before Thanksgiving, I actually bought a few puts.

To some that might seem crazy, the market was up big, and IV was absolutely imploding. To me that was the perfect time to buy a put. IV was sitting near six-month lows and the market was sitting near its highs. 

Here was my logic:

1. I had no market bias. I truly believed we could go up or down.

2. I had little fear of the market implied volatility falling any more.

3. Downside skew would become steeper if at-the-money (ATM) implied volatility falls.

4. There was substantial potential of implied volatility increasing.

Based on these beliefs, I decided that the best play was a put option. This is because if the market fell, my 50/50 bet on market direction would lose as I was expecting to the upside, because of skew and implied volatility NOT falling, the losses would be near what the pricing model projected. However, if the side I bet was right, not only would I make money from the put’s delta, my expectation for implied volatility to increase would cause the put to gain far more than the pricing model predicted.

In my own mind, I produced a trade that had 50/50 odds, but had a payout well above 1-to-1. Maybe not the traditional arbitrage, but to an option trader, this type of volatility bet will lose, often, but over time can pay off like the Bears +2 over the Miami Dolphins.


Article printed from InvestorPlace Media, https://investorplace.com/2010/11/trading-options-with-better-than-5050-odds/.

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