How do you determine risk reward for out of the money option spreads?

Question

Using greeks, i can ascertain the probability of an option being exercised. How can I use the probability and volitilty to determine the best risk/reward option to trade? I have been trying delta neutral strategies - do you think that is a valid approach?

Thanks Zman. I was hoping you would answer. It's clear you have expertise. Do you have a suggestion where i can learn more depth on options as you have? I've read many books.... are you willing to mentor?

going back to the question. If i adjust Implied vol to determine the current option prices - doesn't the associated delta reflect the probability? Do you you always adjust your trade to delta neutral?

Answer 1

<<>>

I'm afraid I disagree. If you assume the implied volatility is correct, you can use the lognormal distribution (not the greeks) to determine the likelihood that the option will be in the money at expiration. However, if you assume the implied volatility is correct there is no reason to trade options.

<<>>

If you are going to use purely statistical criteria, you want to look for skews between options on the same underlying that cannot be attributed to scheduled events.

<<>>

Absolutely. You must control your delta risk. However, you cannot ignore theta, gamma or vega.

As you almost certainly already know, however, a spread that starts out delta neutral is not likely to remain so until expiration. You will probably have to make adjustiments to the spread to keep it delta neutral while keeping the other greeks in control. I believe it is important to determine how you can adjust the spread before opeining it.

Addendum

<<>>

If you haven't read "Option Volatility & Pricing" by Sheldon Natenberg I recommend you read it.

<<>>

While I may know a fair amount, there are others on the Yahoo message boards who know more than I do and have a lot more experience.

If you post on the board at

http://messages.yahoo.com/Business_%26_Finance/Investments/forumview?bn=4686677

you will have the advantage that any incorrect information posted in response is almost always corrected. Unfortnately the board is currently "infested" by some individuals more interested in flame wars than meaningful discussion which makes it something of a pain to use, but good discussions are still possible.

<<>>

Although a lot of people use the delta as a rough approximation of the probability, it is not really accurate. You can get more accurate probabilities from the model.

<<>>

No. I am willing to accept a higher risk in an attempt at a higher return at times. However, when I adjust a spread the adjustment will always reduce the delta risk.

Most of my portfolio is in long-term stock investments. I find it hard to accept that a I need to keep options positions delta neutral when I am willing to have stock positions with deltas in the hundreds or thousands.

If I had most of my portfolio in options spreads I would probably be much more concerned about keeping the spreads delta neutral.