7 Ways to Become a Probability-Powered Trader

October 7, 2024
by RJ Hamster

October 07, 2024 | Read Online

Don Kaufman here.

As I’m writing this, stocks are slipping, with the Dow down about 190 points. We’re seeing headwinds from rising rates and higher oil prices, with the 10-year Treasury yield topping 4% for the first time since August.

But you know what?

This is exactly the kind of market environment where probabilistic thinking shines.

So let’s dive into seven ways you can use probability to make smarter, more profitable trading decisions, no matter what the market throws at us.

Look Beyond the Charts

First things first, let’s talk about charts. They’re useful, sure, but they’re like driving while only looking in the rearview mirror. Charts show you price and volume – what’s already happened.

As probabilistic traders, we need to be forward-looking. So use charts as a starting point, not the whole story.

Action step: Next time you look at a chart, ask yourself: “What does this tell me about future movement?” If the answer is “not much,” you’re on the right track.

Embrace Volatility as Your New Best Friend

Most folks think volatility just means big price swings. But in our world, volatility equals risk. And here’s the kicker – we can actually put a price tag on that risk. Higher volatility means higher risk, but also potentially higher rewards. With oil prices climbing nearly 2% to over $75 per barrel due to Middle East tensions, we’re seeing this play out in real-time.

Action step: Start paying attention to volatility measures like the VVIX for the overall market, or implied volatility for individual stocks.

Think of the VVIX as a “mood swing” predictor for the entire market. The VVIX measures how much the VIX (which itself measures market volatility) is expected to fluctuate.

It’s like trying to guess how changeable the weather will be, rather than just what the weather will be.

A high VVIX suggests that market volatility itself is becoming more volatile, which could signal increased uncertainty or potential for big market moves.

Now, let’s talk a little about implied volatility and what that means.

Let’s compare the implied volatility (IV) for Walmart (WMT) at 22% and NVIDIA (NVDA) at 51% to help readers understand what these numbers mean in practical terms:

Comparing Implied Volatility: Walmart (WMT) at 22% vs. NVIDIA (NVDA) at 51%

Imagine you’re looking at two different roller coasters at an amusement park. Walmart is like a gentle, family-friendly ride, while NVIDIA is more like an extreme thrill ride.

Walmart (WMT) – IV: 22% (options expiring in 32 days)

This lower IV suggests that the market expects Walmart’s stock price to be relatively stable.
Over the next year, there’s about a 68% chance that Walmart’s stock price will stay within 22% above or below its current price.
If Walmart is trading at $100, this means there’s a good chance it will stay between $78 and $122 over the next year.
This stability reflects Walmart’s position as a well-established retail giant with predictable earnings.

NVIDIA (NVDA) – IV: 51% (options expiring in 32 days)

The higher IV indicates that the market expects much larger price swings for NVIDIA.
Over the next year, there’s about a 68% chance that NVIDIA’s stock price will stay within 51% above or below its current price.
If NVIDIA is trading at $100, this means there’s a good chance it will be between $49 and $151 over the next year.
This higher volatility reflects NVIDIA’s position in the fast-moving tech sector, particularly in areas like AI and graphics processing, where rapid changes can significantly impact the company’s value.

What This Means for Traders:

Risk and Reward: NVIDIA offers potentially higher rewards but comes with higher risks. Walmart offers more stability but potentially lower returns.
Options Strategies: Options on NVIDIA will be more expensive due to the higher IV, but they also offer more potential for profit (and loss).
Trading Approach: You might need to be more patient with Walmart, waiting for smaller price movements. With NVIDIA, you’d need to be prepared for larger, possibly faster moves.
Position Sizing: You might feel comfortable with a larger position in Walmart due to its stability, while you might take a smaller position in NVIDIA to manage the higher risk.
Stop Losses and Profit Targets: For NVIDIA, you’d likely set wider stop losses and profit targets to account for the larger expected price swings

Tap into the Options Market’s Crystal Ball

You don’t need to trade options to benefit from their predictive power. The options market is like a massive prediction machine for stock movement. It’s not perfect, but it’s pretty darn good.

Right now, it’s pricing in a lot of uncertainty, which is why we’re seeing higher implied volatilities across the board.

Action step: Even if you’re a stocks-only trader, take a peek at the options chain for your stocks. It’s giving you valuable information about what other traders expect.

Master the Concept of Implied Volatility

Implied volatility tells us how much the market expects a stock to move. It’s like getting a sneak peek at the script before the movie starts.

With earnings season heating up (keep an eye on Delta Air Lines and JPMorgan Chase later this week), implied volatilities are likely to spike for these and related stocks.

Action step: Learn how to calculate expected move based on implied volatility. For a quick estimate, multiply the stock price by the implied volatility percentage and divide by the square root of 252 (trading days in a year) for a daily expected move.

Set Realistic Profit Targets and Stop Losses

Use the expected move to set profit targets and stop losses that make sense. If the expected daily move is $1, don’t set a $5 profit target for a day trade.

This is especially crucial in a market that’s struggling to maintain momentum, like we’re seeing now.

Action step: Before entering a trade, calculate the expected move and use it to set your profit target and stop loss.

If you would like to learn how to get my auto expected move calculator for free, click here to find out more.

Gauge Market Reactions Like a Pro

When news hits, compare the actual move to the expected move. If a stock moves much more than expected, it might signal a significant shift in sentiment.

We saw this with Friday’s stronger-than-expected jobs report, which gave more support to the idea of a “soft landing” for the U.S. economy.

Action step: When the Fed minutes are released on Wednesday or the CPI report comes out on Thursday, compare the market’s reaction to what was expected.

Is the market overreacting or underreacting?

Compare Stocks Based on Probability, Not Just Price

Stocks with higher implied volatility are expected to move more. This can help you choose which stocks to trade based on your risk tolerance and goals.

Right now, with the pullback in third-quarter earnings expectations, we might see some interesting opportunities.

Action step: Create a watchlist of stocks and rank them by implied volatility. This can help you quickly identify potential trades that fit your risk profile.

Bringing it Home

Remember, we’re not fortune tellers. We can’t predict with 100% accuracy whether the S&P 500 will continue its four-week winning streak or if the Dow will hit another record high. But by thinking in terms of probability, we can make more informed decisions and improve our odds of success.

As Sam Stovall from CFRA Research recently noted, ‘Because the earnings bar is now set so low, rarely does one injure themselves falling out of a basement window.’

This colorful analogy suggests that with expectations so low, we might see some positive surprises. However, as probability-powered traders, we’re prepared for any outcome.

Next time you’re about to hit that “buy” button, pause and ask yourself: What’s the probability?

What’s the expected move? Are my expectations realistic given what the options market is telling me?

Trust me, once you start thinking this way, you’ll never look at the markets the same again.

You’ll be making smarter, more informed decisions, and isn’t that what successful trading is all about?

To your success,

Don Kaufman

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