Establishing 84% Probability of Success Put Trades in Bear Markets – March 20, 2023
Selling deep out-of-the-money cash-secured puts in bear markets will provide us with additional protection to the downside in return for lower, but still significant, option returns. This article will highlight the use of Delta and implied volatility to establish a framework for executing such trades with n 84% probability of success.
What is Delta?
This is one of the Option Greeks. There are 3 ways to define Delta. The one related to this topic is the probability of the option expiring in-the-money (or with intrinsic-value) at expiration. If we sell a put option with a Delta of -16 (put value is inversely related to share price), we have (approximately) an 84% probability of avoiding exercise without exit strategies.
What is implied volatility (IV)?
This is a forecast of the security’s price movement as implied by the option’s price movement in the marketplace. Since IV is typically published an annual basis and based on 1 standard deviation, we must use a conversion formula or calculator (we have one, folks) to determine the expected price range of a stock or ETF during a specific contract cycle. Since IV is based on 1 standard deviation (accurate 68% of the time), it will be accurate 84% of the time on the lower and upper ends of the range (68% + 16%).
A real-life example with Jabil, Inc. (NYSE: JBL): IV on 10/19/2022
The BCI Expected Price Movement Calculator (available to premium members) using an annual IV of 38.64%
The spreadsheet guides us to a breakeven price point of $54.06 (circled in red). This will include the strike price – the put premium. As it turns out, the strike with a Delta closest to 16 was the $55.00 strike which had a Delta of 18. No other strike was closer.
Broker platform showing a bid-ask spread of $0.80 – $0.95 for the $55.00 put option
We will enter a put premium of $0.85 into our BCI Trade Management Calculator to establish initial calculations and exit strategy price points.
JBL: Initial calculations using the BCI Trade Management Calculator
Note the following for this 84% probability of success trade:
- Breakeven price point is $54.15 (yellow cell in the middle of the image), approximating our target of $54.06 (expected price movement calculator)
- The 31-day initial return is 1.57%, 18.48% annualized (blue cells)
- If we allow the put to be exercised (if ITM at expiration), we will have purchased JBL at a discount of 10.94% from the price at trade initiation (brown cell)
- The exit strategy price points are calculated in the yellow cells at the bottom of the image
Discussion
Defensive put-selling strike selections can be determined by using Delta and/or implied volatility. The use of these data points can assist us in establishing (approximately) 84% probability successful trades.
Author: Alan Ellman