A key component of an efficient market maintains that prices are so well founded that no strategy can create a long-term positive return. We can demonstrate this with the expected payoff formula:
Expected Payoff = (x * p) – (y*[1-p]) where x is the potential profit, y is the potential loss and p is the probability of winning.Example 1:
- A scalping trade (A 50/50 shot in theory)
- Either profit $100 or lose $100.
Expected Payoff = ($100 * 0.5) – ($100 * 0.5) = $0.00.
That said, does this same logic apply to the world of options? Particularly, short premium trades?
With the use of historical data and averages, the tastytrade Research Department demonstrates the edge inherent in trading options.Example 2:
Since 2010, the S&P 500 has stayed within the 1(16 delta) 84% of the time versus the theoretical 68%. Thus, our probability of winning on a short 16 delta strangle is 84%.
When SPY moves past its 1 standard deviation strikes, it exceeds the strikes by an average of 1.7% which we can view as our potential loss. When SPY stays inside its 1 standard deviation, we keep the credit from the trade. This has been 1% of the stock price (on average), and we can view this as our potential profit.
Thus, our expected payoff for short 16strangles on SPY is equal to:
Expected Payoff = (1% * .84) – (1.7% * 0.16) = 0.6% of the underlying price.
Ultimately, most markets are efficient in that their price shows no strategic edge for long or short positions in the long run. This has not held true for selling insurance via the options market, which has a positive expected payoff.
Tune in as Tom and Tony break down these results and discuss the most important takeaways.