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Educational Article

# What's My Probability\?

HAVING TROUBLE PRINTING?

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.