*right*things. So busy were they teaching me the difference between a call and a put, a Bid and an Ask, that the whole idea of defining risk was, at best, paid lip service. Yes, yes, you must protect your capital...but in the beginning, nobody tells you HOW to do that. They just assume you are going to lose a few, part of the learning process. How very unfair!~ A few can turn into many without the tools you need.

**PROBABILITY**

Since I started learning spreads and some of the more advanced strategies, I realized that a trader needs to have a good sense of the odds of her trade being successful. What is the probability that this trade will make money, and/or more importantly, NOT LOSE MONEY?

I bought Calls and Puts for a couple of years without a full understanding of these basic principles: protect your capital and compute your risk.

This might give you an idea (if you are a beginner) of the things you should know before leaving the paper trading mode, and using your real money.

The first trade you usually make is buying a Call, right? Beginners go long, and buy a Call or a Put. Toe in the water time. So what is the logic that goes on?

Okay, in this example, you look at an option chain. The stock is at $132. If you are buying a Call, then your expectation is that the stock is going to go up. You will note in the option chain below that the "At the Money" strike price has a Delta of .52 and a probability of going "In the Money" (by at least one cent) is 50.39%. These two figures are VERY close, and that is why traders often use DELTA has a "loose" probability calculator. In this ThinkorSwim chain, the probability column is built into the chain but not all brokers have this feature, so you can use DELTA instead.

So,what does that mean? It means that AT EXPIRATION, the 132 Strike option has a 50% chance of being in the money. Sort of like Vegas? Heads or tails, 50-50 chance.

So, a typical beginner's logic (without thinking about probability or risk) would be to buy the $133 or $134 Strike, because for sure the stock can go up a dollar or two, right?! And thus she'll have a winning trade!

But think about this for a minute. If the stock moves to $134, would she really have a winning trade? No! And why not? Because she paid $1.52 for the option. So before she comes into profit, the stock has to get to $135.52 ($134 plus $1.52). And if you look at the option chain above, what is the Delta and probability % for the $135 Strike? We have gone from an almost 40% probability down to a 30% probability just by knowing our break-even. How are those odds looking now? Not too great. A 70% chance of losing on this trade,right?

Well, that's easy to remedy, says the Beginner. She'll just buy a Call that is DEEP IN THE MONEY. How about the $127 Strike. It's sure to be in the money, look at that chain; it has a 79.96% probability of being in the money!

But wait. Don't forget the break-even calculation. The stock has to be at $127 PLUS THE COST OF THE OPTION which in this case is $6.19. So now your break-even stock price is $133.19 ($127 plus $6.19)-- and that moves you down, down, down the chain to the $133 strike which is only a 44% probability of success.

Are you beginning to see how such small treasures of information can inform your trading choices? NOBODY explained this to me. I bought Calls ITM, OTM and ATM and if I happened to win on them, it was entirely due to volatility and some huge movement that I wasn't even aware of. It certainly wasn't because of my choice of strike price! I blindly traded Calls and Puts with no probability thoughts at all. It's a great way to lose your cash fast.

In fact, at this late date, I would say buying "plain" calls or puts (without protecting them in a spread) is a sucker's game and one that the market makers are getting rich from.

I hope you 'get' this little lesson and continue with your studies. This should be an eye opener if you have ever had what looked to be an option that was in the money, but you made no profit. This explains why.

**DEFINING RISK**

Okay, if you're with me this far, you might wonder how then does a trader define risk? Probability is surely one factor, but are there others?

**How much are you willing to Lose?**When you go long on options (without doing a protective spread) your risk is limited to the amount you paid for the call or put. So the first question you should ask yourself when you look at the Ask Price. Am I willing to lose this much money? In the case of the Deep ITM call above, you would be risking $619.00 for ONE contract, with a 44% chance of winning. Ouch.

**Comparing one trade to another**

If you did a SPREAD, you could compute the difference between doing plain calls/puts and the risk and probability of having some protection.

In the plain Calls discussed above, your risk would be the cost of the premium:

Strike $134 - Risk $1.52 ($152 per contract)Probability of success 30%

Strike $127 - Risk $6.19 ($619 per contract)Probability of success 44%

But let's say we did a CREDIT SPREAD instead. If we were really feeling bullish, we would like do a credit spread on the Put side, but for example, let's do a bear call spread: Let's say we SELL the $137 Strike, and BUY the $138 Strike. The difference in the Bid of the Short Call and Ask of the Long Call would net us $.24 cents in our pocket, no out of pocket outlay at all. If I bought 10 contracts, that would be $240 in my pocket.

We want the stock price to stay BELOW our Short Call of $137. If it does, both options will expire worthless and I'll keep the $240. So what is the probability that I will get to keep that $240? The chain says that the Short Call at $137 has a 21.26% of going in the money. Well, this is CREDIT spread, so we don't WANT to go in the money. We want to stay out of the money until expiration. So that means there's a 78.74% (100 less 21.26%) probability that I will NOT go in the money, which is what I want. (just the opposite of going long on Calls)

**How Do You Calculate the Risk on a Credit Spread?**

Take the two Strike prices of your Vertical Spread: Difference between long and short strikes ($138 less $137)= 1.00 less the credit received $.24 = $.76 risk per contract.

Strike $137 (SHORT Call) - Risk $.76 ($76 per contract) Probability of success 78.74%

Now I ask you. When someone teaches you what a call and a put are, don't you think they should show you a few things first? Nobody showed me. I lost a lot of dough. I hope I can save you some.

P.S. If you don't use ThinkOrSwim software and don't have "probability %" on your option chains, don't despair. Just use the Delta as your gauge. It's close enough. These are not set in stone anyway, just possible outcomes given the history of this stock.

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A great book if your interesting in knowing more details of how options are priced is "Options and Options Trading" by Robert Ward. It's one of my favorites.

ReplyDeletePretty much goes into detail in a similar manner of what you said. A call/put is priced according to its "expected" volatility, so anytime you buy a long call or put, the odds are baked in...

Thanks! I'll check it out!

ReplyDeleteGreat Article! Two things. 1. is the title of this blog incorrect? "Wall Street, MEAN Street." Do you mean MAIN Street?? 2. You mention in your post that the probability number is associated with Delta. Do you or anyone else know where TOS or TDAmeritrade came up with the actual number? like what formula they use? Thanks in advance.

ReplyDeleteWell, Main Street was pretty mean to me while Wall Street just kept doing better, so the change in title was a bit of tongue in cheek on my part.

DeleteMany people roughly associate Delta with Probability. If the Delta is 10, it's likely got a 10% chance of going into the money. Another way to look at it is

that Delta represents approximate shares of stock. Since one option contract represents 100 shares (in the money 100%) if the Delta is 10, then you've got the equivalent of 10 shares But the probability %'s that are published on TOS are based on an actual formula which I would have to dig out of the videos in the Tasty Trade archive, (and will when I get some time) and there are many many other videos there that explain why technical and fundamental analysis based on the PAST do NOT predict the future, (and are a waste of time in a 50-50 random outcome of any given trade on any given underlying) and why probability trading combined with option strategy is the only chance for mechanical success (and that must be multiple trades in small lots for the probabilities to work out.) Let

me find some videos and I'll link them here for you.

Here's one video: Probabilities and IV 3/11/13: explaining how pricing models (done by Market Makers) make near perfect market prices on which probability theory can be based. Market Measure on Probabilities and IV

DeleteIf you get into Tasty Trade archives and just begin to put words into their Search Engine (on the left), you will find a TON of data related to this.

DeleteThey have a guy, Jacob, (a professor who teaches probability theory) in a whole bunch of mathematical videos which go DEEP into this, if you really want

formulas. The Skinny on Option Math is the segment they do with him.