Option Investor
Educational Article

What's My Probability\?

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I got lots of e-mails regarding my last article which included a segment on "probability of profit". It's a tool that will help give you an idea of how successful your strategy may or may not be. A probability calculator will calculate for you the chances of the underlying stock hitting a certain point by expiration. These calculations are based on real mathematical and statistical theories and not some guru's "best advice". These are your true odds of where the stock might end up by expiration day using the formulas inherent in the Nobel Prize winning Black-Scholes model.

Your probability of profit is very dependent upon the volatility figure that must be incorporated into the calculation. The volatility figure can be either the "implied volatility" of the options, or your own guess of "future volatility". It's hard to say which form of volatility you should use but I lean towards using implied volatility because it is a number which is a consensus of all the market participants. You could even use an average of the implied and your own guess to give yourself a mixture of numbers.

The calculations themselves are pretty complex and not worth putting into text here. If you have a probability calculator you don't have to even worry about the calculations because it's all done for you. It just tells you the chances of stock XYZ being at price ABC on expiration day. As I mentioned last week, most option-buying strategies will fall into a range of 20-35%, and in some cases even lower than that. When you buy an out-of-the- money option, your chances of success begin to get very low, like less than 10%. On the flipside, option-selling strategies can give chances of success close to 90%. This is where a majority of the slow steady money can be made. You don't even have to sell naked options to achieve this percentage. The key is to trade credit spreads. It can be credit spreads on the indexes or on any individual stock. In most cases, you should concentrate on selling out-of-the-money credit spreads on stocks or indexes with higher than average volatility.

One key factor in determining whether you'll achieve a higher probability of success, is to sell these credit spreads when volatility is on the high side. I've talked about this many times in the past. Check your option chains and volatility charts to see what level of volatility your stock is trading at compared to its past. Don't sell options when volatility is making new lows. This is because you won't get enough bang for your buck, and because sooner or later the volatility will start turning back up towards its natural range. If this happens, option prices tend to get more expensive even though the stock might have not moved anywhere. Your short options will most likely start to move against you in this case. If you want to sell credit spreads on the OEX, take a look at a chart of the VIX. This is a barometer that is talked about extensively on this website. The VIX is not only used to signal a possible turning point in the direction of the market in general, but it is also an indicator of how cheap or expensive the OEX options are. Right now the VIX is hovering near its lows of 22. This means that options are very cheap at the moment. So this might not be the most opportune time to sell credit spreads.

The great thing about credit spreads is that you always know how much you have at risk and how much your potential reward may be. The maximum risk is calculated by taking the difference between the strike prices of the trade and subtracting the credit. Here's an example: YHOO is trading at $132 1/2, the August $120/$115 put credit spread is trading for roughly $1. To figure out your risk/reward, just take the difference between the strikes (120-115)=5 and then subtract the premium received (1)= $4. To put it in actual dollar terms, just multiply by 100. So your total risk is $400 and your total reward is $100. This is assuming you are doing just 1 spread. If you are doing 5 spreads, just multiply all the dollar figures by 5. In this case, risk would be $2000 and reward would be $500. Using the actual numbers above, my probability calculator says that this spread has about a 76% chance of staying above my break-even price of $119.00 using 25 days left to expiration and 57% volatility. To figure out your break-even price, just subtract the premium received from the strike price of the sold option. In this case that is ($120-$1) =$119. Of course you could use further out-of-the-money options, but the credit you receive will be less, but your probability of profit is higher. We could sell the August YHOO $110/$105 put spread for $.50 and our probability of keeping this credit moves up to 83.5%. It's all about trade-offs. Do you want more premium or a higher probability of success? You decide.

The credit spreads don't have to be one sided. You can sell dual credit spreads on both the puts and calls. If you find a stock that is stuck in a trading range; you can sell a put credit spread and a call credit spread at the same time using the same expiration month. These could be potentially good trades during the summer doldrums when stocks can't really seem to make up their minds of which way to move. If your long-term bias is to the upside, you might just want to stick with selling put credit spreads because these will expire worthless as long as the stock keeps going up. Check the charts for support and resistance levels. This will give you another idea of which strikes to set your spreads at.

It all sounds pretty good, doesn't it? But of course there are always the drawbacks. Sorry. It's really not that bad. Sometimes you may sell a credit spread and the stock will start to move through your short strike. That's okay because you know what your maximum loss can be at anytime. You have 3 choices. You can either wait it out and hopefully the stock will turn around and go the other way, you can close it out for a small loss, or close it out and roll the spread to farther out strikes. If you've picked the right strikes and checked your support and resistance levels, most likely the adverse move will only be temporary and the stock will start to move in your favor.

The other potential drawback of course, is that no matter what kind of great odds you have by selling credit spreads (e.g. 90%), you never know what might happen to the stock. There could be a takeover announcement or a huge earnings warning. Either one of these events can cause large movements in either direction of the stock and possibly shoot through your short option very quickly. The best ways to get around these potential dangers is to sell spreads with one to two months before expiration, which gives less time for the premiums to go higher in case of an unexpected event, and to possibly concentrate on selling spreads on the indexes (SPX, OEX), which are not prone to the huge gaps that can affect any individual stock.

Lastly, just remember that your probability of profit is the figure you get at the exact time that you put on your trade. It will be constantly changing when the market conditions change. It may move higher or lower depending on the price of the stock, days to expiration, and whether volatility has moved up or down. Check it every now and again and see if you're still comfortable with the probability. You can always close it out at anytime and of course you will always know exactly how much you can make or lose no matter what happens.

Good luck.

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