High Probability Trading Strategy

The price of any asset can rise, fall or remain unchanged during any period of time. The probability of each outcome is 33.33%. Therefore, the probability of achieving a profit (success) for a long or short position in any asset is 33.33%. But, the probability of success for a short ATM (at-the-money) call or put option is 66.66%. A short call option is profitable if the underlying security price fall or remain unchanged. A short put option is profitable if the underlying security price rise or remain unchanged. The probability of success is even higher for a short OTM (out-of-the-money) call/put option and highest for the farthest OTM strike option.  QA (Quantitative analysis) is utilized to select the closest strike price with a high probability of remaining OTM at expiration. TA (Technical analysis) is also applied to the underlying security to provide a high probability of success in terms of timing the trade. The methodology discussed thus far can be applied to any security with tradable options. However, applying this methodology to a “futures-term-structure” based ETP (Exchange Traded Product) provides an additional increase in probability of success.

Futures-term-structure based ETP price is affected by both the futures price and the state of the futures term structure price curve. The shape of the futures price curve can be in a state of contango or backwardation. Volatility Futures-term-structure based ETPs lose value when their futures term structure are in state of contango and gain value when in backwardation. For example, VIX futures are in state of contango much longer periods of time than in backwardation. The very short explanation of this is because markets have an upward bias in the long run. Thus, in the long run the price of these ETPs fall toward zero forever. VXX is one example of a VIX futures-term structure based exchange traded product with tradable options. Furthermore, volatility is mean reverting and that adds further high probability to the price direction after an extreme move. Volatility tends to make extreme move up and therefore the mean-reverting direction is down.

To summarize, utilizing TA/QA to short OTM Call option of a futures-term-structure based ETP that tracks a mean reverting index equals a very high probability of success.

Contact mike.davoudi@gmail.com if you are interested in learning how to apply this strategy.