“Trade small and trade often.” You’ll hear that frequently while watching tastylive. We say that because we believe in our research and that with a high enough number of occurrences gives us the best chance of trading success. How do we decide though what to trade and how much? That’s especially important in a tastyBITE sized account. What factors do we look to and why?
The Probability of Profit (POP) of a strategy and trade as well as the correlation of underlyings are two key factors to consider. Trades with a lower POP usually have larger profit potential but should receive a minimal percentage of trading capital. Our studies direct us to allocate most of our capital to high probability trades. The Skinny on Options Data Science from December 31, 2015: “Am I Underestimating My Risk?” provides the info to show how choosing high POP trades places the odds on our side and allows the law of large numbers to work for us when we are selling option premium. A table displayed the odds of losing once, and consecutive losses of 3, 5 and 10 times. It did this for trades with an initial POP of 50%, 67%, 75% and 95%. The chance of 3 consecutive losses in trades with a 50% POP is 1 in 8 but when the POP is 75% it’s 1 in 64. Ten consecutive losses at 50% POP is a 1 in 1024 chance. It’s a 1 in 10.2 TRILLION chance when the POP is at 95%. This is all true though only when we have uncorrelated positions.
Correlation then is the other key factor that traders need to consider. The Skinny on Options Data Science from June 23, 2016: “Confusion with Statistics,” explained why correlation is so important to our chances of success. A table showed that the chance that 5 correlated trades that each have a 70% POP will all fail is 30%. When the trades are uncorrelated though the chance of all five failing is just 0.24%. A second table compared Straddles versus Strangles in either SPY with IWM which have a correlation of 0.93 or SPY and GDX in which -0.03 is the correlation. The Straddles in the SPY/IWM combo have a 50% of seeing both fail while it is only 25% for the SPY/GDX combo. The higher probability 1 Standard Deviation Strangles show both failing at 30% for the high correlation pair and only 9% for the low correlation pair.
Watch this segment of tasty BITES with Tom Sosnoff and Tony Battista for the key takeaways of the true importance of sizing through POP and correlation in a tastyBite sized account.
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