Turning Options Trading Ideas into Profits

08/29/2013 8:00 am EST

Focus: OPTIONS

When buying or selling options, it is very important that you understand probabilities and how they might impact your positions and trading decisions, say Seth Freudberg and Michael Schwartz of SMB Capital.

Is there a method to determine the probability of an options trade?

One of the terrific characteristics of trading options versus trading stocks is that there are methods of calculating probability of profit before you initiate the trade.

The features of time decay, strike price, and option volatility are unique to options trading strategies and apply whether you are buying a call option or selling a put option.

Before we get into detail, keep in mind that probability of profit is a statistic, not a guarantee. You should theoretically see the odds play out over time, but not from trade to trade.

The first method of determining probability of profit is to simply look at the “Greek” known as the “delta” of an option, a parameter which any options trading platform should supply. Delta is used to determine the movement of the options price as compared to a one point move in the underlying. So a delta of .10 would mean that a one point increase in the underlying would produce a \$.10 increase in the call option with a delta of .10.

However, you can also use the delta as an approximation of the probability that the option will expire in the money. The call option with a delta of .10 has a 10% chance of expiring in the money. That’s why many option traders when selling options look at its delta in the decision-making process.

The second method is to use your trading platform to provide you with the actual statistical probability that a strike will expire in the money. If you look at an options chain, within certain trading platforms, you can customize the columns and change them to reflect lots of different kinds of information about that particular option, including the probability of it expiring in or out of the money.

While looking on a particular day in early August at a .11 delta call option of the SPX that expired in August 2013, for example, the probability of that option expiring in the money is 10.11%. So you can see how close the two numbers are, and for the most part, the difference between looking at deltas or probabilities of expiring in the money is negligible.

One important fact that many new to trading options either ignore (or don’t realize) is that the probability of an option expiring in or out of the money assumes the person holds a short option until expiration day. This might be more than most traders can handle from a risk tolerance standpoint when considering the probability of the short strike being touched is much higher as the market price gets close to the strike.

Speaking of which, there is yet a third metric, the probability of being touched, which refers to the chances that the underlying will touch the strike price of your option at least once prior to it expiring. Again we have a short cut to determine this parameter, which is to take the option delta and double it.

So a .10 delta call has approximately a 20% chance that the underlying will touch it sometime before expiration. Certain platforms will calculate this for you. Using the same .11 delta call option in the SPX has a probability of touching equal to 20.39% for example. Again, very close to our “shortcut” estimate.

When selling and buying options it is very important that you understand probabilities and how they might impact your positions and trading decisions.

By Seth Freudberg and Michael Schwartz of SMB Capital