Hello OptionBoxers, with football season winding down and more time to focus on the markets I’ve been giving a great deal of thought to options trading expectancy. Specifically, how many trades must be won to profit after commissions are deducted? My assumption, incorrectly I’ll add, has always been that a 50% win rate or higher would be profitable. However, in the paragraphs below I’m going to dive into expectancy headfirst to uncover any nuggets of wisdom that may exist.

Options Expectancy Formula – Theoretical

(Probability of profit X Average Gain) – (Probability of loss X Average Loss)

To begin, I’ll want to evaluate options expectancy from a theoretical perspective. I could forgo this process if I’d been trading a specific options strategy for any length of time because I’d already have solid data to compute my true expectancy. In the absence of solid data I think it prudent to calculate several options strategies theoretical expectancy. For this example, I’ll consider just the bull put spread but likely an assessment of multiple strategies would be beneficial.

You’ll likely have noticed that without actual data to input I’ll need to make a few assumptions to complete the calculation. Namely, the average gain and the average loss. However, I don’t want to make this an exercise in rocket science so I’ll include my average gain as 65% of the maximum profit and my average loss as 50% of the maximum loss. This will provide a foundation from which to build, if nothing else.

Bull Put Spread Strategy Options Expectancy – Nike (NKE)

Using the above example, 1.00(strike width) – .41(credit received) = .59 or 59% Probability of Profit

Average gain assumption = .41 X .60 = $26.65

Average loss assumption = .59 X .50 = $29.50

The expectancy formula would calculate as follows;

(.59 X $26.65) – (.41 X $29.50) = (15.7235) – (12.095) = $3.63(profit p/trade) – $2.60 (my commission cost round trip) = $1.03 profit p/trade

Therefore, If I anticipated trading this strategy 100 times, I can theoretically expect to earn $103 dollars after deducting commissions. Not great, in my opinion, but profitable nevertheless.

That said, using Thinkorswim’s thinkback tool I’ll enter 10 different trades using the above criteria(or as close to it as possible) to gather a small sample of data from which to continue our discussion. The hope is by exiting at less than the maximum profit I’ll be able to close trades for a profit that may otherwise become a loss and I’ll be able to deploy more trades over time. Conversely, closing at less than a maximum loss could also eliminate trades that may have otherwise become profitable so there could be somewhat of a trade off.

Nike Bull Put Spreads using ThinkBack on ThinkorSwim

If these ten sample trades were any indication of profit potential long term then this strategy would be much more profitable than was originally expected. However, don’t forget that markets tend to move up and DOWN so its clear the random date I picked was able to benefit from a bullish trend that was in process. Extrapolate this data over 100 trades and it becomes much more likely our original expectancy assumption would hold true. Therefore, the theoretical options trading expectancy formula does indeed add value in the development of a trading agenda.

That said, lets continue our discussion by analyzing the actual trade data collected above to see if any other insights exists before we wrap things up.

Options Expectancy Formula – Actual

(Win % X Average Gain) – (Loss % X Average Loss)

Win Rate = 7/10 = 70%

Loss Rate = 3/10 = 30%

Average Gain = $23.77

Average Loss = $29.83

The options expectancy formula would calculate as follows;

(.70 X $23.77) – (.30 X $29.83) = ($16.639) – ($8.949) = $7.69(profit p/trade) – $2.60(round trip commission cost) = $5.09 profit p/trade.

Conclusion

After considering both the hypothetical as well as the actual data that was collected I think its safe to conclude that considering options expectancy is well worth the effort before undertaking a trading strategy. While it is apparent the data I collected benefited from an ongoing bullish trend in Nike it didn’t disprove the reliability of the theoretical formula. In fact, quite the opposite. The strategy could be potentially more profitable than was expected. Should this approach be utilized in conjunction with a technical analysis indicator for more advantageous bullish setup, it could be reasonably argued that over 100 trades a trader will expect to earn greater than the $103 dollars that was originally expected. Of course, more testing and more data would ultimately prove or disprove the argument.

For anyone eager to continue their study of options expectancy I highly recommend this article from Vantage Point Trading that helped to solidify the concept for me in my own trading.

Final Thought

Lastly, it should now be clear that earning a profit will require more than just winning half the trades we take. However, the trading parameters used above could be altered in many ways and probably should be to fit your desired risk tolerance. So, I do suppose it’s possible to conduct a strategy that becomes profitable by winning slightly more than 50% of the time but I think I’ll leave that to each of you to decide.

God bless,

Jeff

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