Hi Mark,

I would like to know how to correctly calculate (and use) the “probability of profit” tool…

Everywhere I look amongst the options sellers I read about it, and, behind the obvious, I think it may be an useful tool, but only if correctly understood (and used).

Do you calculate it by yourself? Do you trust any site in particular?

Thanks, as always

Roberto

***

Hi Roberto,

‘Probability of profit’ is not something I calculate. Too many variables are involved (*see* below).

However, these items can be calculated

a) Probability that an option will finish in the money (i.e., be ITM) at expiration

b) Probability that any underlying asset will move to touch the strike price (i.e., the option becomes ATM or ITM) of any of your short options *at any time* during its lifetime, even when it does not ‘finish’ ITM

c) Probability that an underlying will move to touch any specific price (presumably your target exit price) at any time during the lifetime of the option. And you can set the ‘expiration’ date of the option to coincide with your planned exit date – for traders who prefer not to hold through expiration.

We cannot determine probability of profit because certain events may occur and each of them affects the final outcome: profit or loss. For example, you may make an adjustment or exit quickly with a small profit.

There is no way to determine WHEN the underlying may reach the point at which you plan to exit. You can determine the probability of reaching that price, but the time elapsed before that occurs determines whether you earned a profit [If you exit when the option is still OTM for example, you could have a profit if enough time has elapsed]

There is no way to know the implied volatility of the options at whatever future time you would choose to exit. If you close the position on at unknown date and when options are trading with an unknown implied volatility, there is no way to know if the position will be profitable.

No. I do NOT calculate this myself. Some brokers offer the tool that calculates ‘the probability of touching.’ I prefer to use, and trust, the free software made available by Peter Hoadley.

To make it work, set the strike price (or any other stock price of interest) and expiration day (or any other date. If you plan to exit early, there is no reason to use the option expiration date. Use your planned exit). Select a volatility for the calculations, with your best bet being the current IV of the specific option that concerns you.

The calculator output gives the probability of touching at some point. It does not give probability of profit. Note: Even when option finishes ITM, it may be a profitable trade – if it is ITM by a small amount.

882

New Issue published today

Monday, Jan 24, 2011