Last week week marked the beginning of my favorite sports-related time of year – the NCAA Basketball Tournament, or March Madness. It’s the only time I really get excited about sports for a few reasons: The tournament is wonderfully balanced; any team can win; a #1 seed has never lost in the first round – yet; and I love to see the underdogs win, even if it kills my brackets! I always play the higher probabilities even though the long shots tend to inflict the most damage.
My approach to options trading is similar. I look for the best trade probabilities, but I am always keenly aware that long shots exist. Playing the long shots is not a horrible idea – when they perform, the payoff can be substantial. As option traders know, the leverage we have with options on those low probability stocks make for some very nice gains. But it’s important to point out that we don’t look for those on a regular basis.
Why not? Well, for the same reasons we don’t put all of our money on the line for the underdogs during March Madness. Top seeds are ranked high for a reason. While it may be razor thin differences that separate those teams from the others, they have the confidence and skills to come out swinging hard despite the incredible pressure to win.
Options trading is very similar. Taking a higher delta, or a higher probability play, affords the luxury of having some intrinsic value or more time to let a trade work. A low probability bet, on the other hand, might pay off 5% of the time or less. You can have a great system, but if the odds are not in your favor, you may lose far more often than you win. When that big win actually does come in, how far behind are you? Will it just get you back to even?
When filling out your March Madness bracket, you probably have at least one top seed headed to the Final 4. How do you know? You’ve got history on your side – it’s not often that have we seen a Final 4 without a #1 seed represented. Trading is no different. We flock to the names that show reliable patterns and trends, and thus the best odds for winning. Traders will put money behind names like Tesla, Netflix, Google, Amazon and Apple when the market is running hard to the upside, and they’ll go short when the flow of money is moving in the other direction. That’s where the money is made. These top seeds are an ATM machine if you’re on the right side with the right timing.
Enjoy the rest of the tournament, and enjoy those high probability trades. You’ll find yourself ringing the cash register much more often.