What if you focused on a price you think a stock won’t hit? It might seem counterintuitive until you see the numbers.
When we were kids, our birthday was the greatest day of the year. Our minds raced with the possibilities of the gifts we’d receive. Truth is, it was probably easier to figure out what presents we wouldn’t get. I would have loved a life-size army tank but that wasn’t going to happen.
We can think about options trading in a similar way. If an investor buys a call option, he or she might have a vision of the perfect scenario: the stock gliding to exactly the predicted price with perhaps a tidy profit pocketed. Unfortunately, it doesn’t always play out that way. Anything can happen in one trade. But over a large number of options trades, high probabilities are what matter most.
So options traders can take one of two approaches. They can try to predict where the stock is likely to arrive at some future point which is basically impossible because you can’t predict the future. Or, they can place trades based on where the stock is not likely to go, an approach that tends to offer a higher-probability outcome.
The Theory, In Practice
Suppose you buy a call option in XYZ stock because you’re bullish. The option’s strike price is $95 and the cost is $2.29 per contract plus transaction costs (see Figure 1). The option’s delta, a measure of an option’s sensitivity to changes in the price of the underlying asset, is often used by option traders to estimate the probability of an option ending up in the money (ITM) at expiration—50% in this example. This is based on option pricing models such as Black-Scholes and the assumption that an at-the-money option with a delta of .50 will have a 50/50 chance of being either ITM or out-of-the-money (OTM) at that moment in time, all other things remaining the same. For this trade to make money, the stock has to be above the trade’s breakeven point of $97.29—that’s the strike price ($95), plus the option’s cost ($2.29), not including transaction costs. In our sample’s option chain, we see that the odds of being above $97 at expiration are only 36%.
The odds here are obviously not in the trader’s favor. Still, some traders would jump at this trade because its allure is the unlimited gain potential— the higher the stock goes, the more profits the option can make. Of course, that all hinges on whether the stock moves and stays higher. Yet, no guarantees, right? The trader is putting the entire amount of money invested in the option at risk. Should the option expire worthless, the entire cost of the option position would be lost.
The Other Side Of The Ledger
High-probability options trading involves sacrificing the unlimited-gain potential by putting the odds in your favor. A high-probability strategy usually involves selling out-of-the-money (OTM) options that have a higher likelihood of staying OTM. This is done through strategies such as selling naked options, which can carry a substantial risk of loss, or with short vertical spreads, which have more defined risk.
A high-probability version of the previous trade example would involve moving to the put side and putting on a short-put vertical spread. A trader might sell the $93 strike put and buy the $92 strike (see Figure 2). The trade’s potential profit is limited to the credit collected, which is the difference between the bid price ($1.67) of the sold put, and the ask price ($1.41) of the purchased put—in this case, $.26 per contract (less transaction costs).
In order for the trade to work, the options have to stay OTM. In other words, the stock must stay above $93 until expiration. Again, delta reveals our potential odds. The delta of the $93 strike put is .37—based on our earlier discussion of using delta to estimate the likelihood of an option expiring in the money, we could imply that there is a 37% probability of this option ending up ITM (where you don’t want it to be). This also implies that there is a 63% chance of this option ending up OTM. Here the trade risk is limited to the strike difference ($1), minus the credit received ($.26)—in this case, 74¢ per contract plus transaction costs.
Each investor has to decide if they’re comfortable with odds north of 60%, or completely uncomfortable with odds below 40%, or whatever odds your particular strategy and delta might indicate. And as always, fees and other brokerage transaction costs apply and should be weighed before entering any trade. But the percentages do show that just like coveted birthday gifts, it might be easier to predict what’s not in the box than venture a guess at what’s under the shiny paper or about to roll up in the driveway.