Probability of Profit in an Options Trade

Focus: STOCKS

Juan Sarmiento Image Juan Sarmiento Independent Trader, putcallgenie.com

Traders have an advantage over stock buyers, particularly when the markets are at or near their all-time highs. says Juan I. Sarmiento, DVM, PhD, President and Founder of PutCallGenie. He uses AAPL as an example.

In my previous article Trading Call Options, I discussed buying call options as an alternative to buying plain shares of stock. When we buy shares of stock, the probability of making a profit (more than $0.01) is 50%. When we buy a call option with a strike price that is at or near the current market price of the stock (this option is said to be “At-The-Money” or ATM), our probability of success is much less than 50%, mainly because we are paying for an additional time and volatility values which will evaporate by expiration.

Here is how to increase our probability of profit in an options trade.

Option traders usually try to neutralize the negative effects that time, decay, and volatility tend to erode the value of the option and overvalue the price of an option at entry, respectively.

The most common approach is to sell an “Out-of-The-Money” (OTM) option simultaneously with the purchase of the ATM option. Ideally, both the option being bought and the option being sold have the same expiration date, so that most of the time decay is neutralized. In addition, both options also have similar implied volatilities. In effect, we are buying and selling implied volatility, which neutralize each other and hence neutralize the effect of “Vega.” This Vega measures the increase (or decrease) in the value of an option with every point of increase or decline in its implied volatility.

Since both time value (Theta) and Vega contribute to the “extrinsic” value, which will be worth $0 at expiration, it makes sense to want to neutralize its effect as much as possible.