Hamp also wrote amessage on this board answering what he looked for as far as a criteria for writing put spread. As I remeber it stated at leeast *.60 in premium and he looked for a .67 chance of winning I think. Does anyone have the message number of that post?
I can't find the link, but I recall Hamp saying that he liked credit spreads that have a probability of success greater than 50% and less than 70%. The reason was more psychological than anything else. He wanted to win a majority of the time, but still keep his risk/reward manageable at no more than around 2-to-1 (70/30). Very high probability trades are no good because although you win most of the time, the few times you lose are devastating and wipe out a great many of your winning trades (which is depressing and bad for the psyche). He also said that these probabilities are based on market neutrality (i.e., the stock price is assumed to reflect fair value). Consequently, if you have a variant view and see the stock price as either under- or over-valued, you need to adjust the implied probabilities of success -- which are based on the implied volatility of the options -- more in line with your variant view of fair value. For example, if a stock is trading at 50, a 50/45 put spread may yield a premium of 2.50, which implies that the probability of making at least a penny profit is 50% (1-2.50/5). But if you think the stock is undervalued at 50, then the actual probability of winning is higher than 50% and receiving a 2.50 premium actually creates a positive expected value from the trade instead of zero.Rwanda
Best Of |
Favorites & Replies |
Start a New Board |
My Fool |