Pot Odds

The term “pot odds” refers to the statistical relationship between expected return and expected risk. If we have good pot odds on a trade, we can expect to make more than what we’ve risked. For example, we would risk two to make three, but we would not risk four to make three in a random environment.

To put this into trading context, if we sell a one point wide vertical spread and we receive a credit of 20 cents, the most we can lose is 80 cents. Theoretically, if we do not manage the trade, over a large number of occurrences we would need to be right at least 80% of the time to break even. This also assumes we experience a full loss for all of our losing trades, which does not happen every time.

In trading, if our probabilities are directly correlated with the credit we receive it is a zero sum game. The reason this theory does not completely correlate with trading is because it only takes price direction into the equation. At tastytrade, we primarily focus on other factors that give us an edge.

IV contraction and expansion are both ways we can profit without a change in the underlying’s price. Our main objective is to sell premium when IV is high because price direction is hard to read. As contrarians, or mean reversion traders, we can also pinpoint price extremes and trade them accordingly. IV reversion, price reversion, rolling, and managing winners are all ways we can mechanically alter our pot odds and skew them in our favor.

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