SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Option Payoff Probability


Many options analyses focus on profit, loss and breakeven. These show what occurs on expiration day, assuming the option remains open to that point. But this is not realistic. Most options are closed or exercised before expiration, is calculation of how probable a payoff is going to be, how likely the loss, or the exact neutral outcome (breakeven), are all unrealistic.

In the real world the single modeling of outcomes based on remaining open until expiration day, fail to consider several unknown and unanticipated random variables.

The easily calculated breakeven is easily calculated. Above or below that level, either profit or loss can mean many different things. When either are at maximum, you know the outcome exists within a range of possibilities. When maximum profit or loss are unlimited, it is more difficulty to identify probability beyond a rather simplified assumption: The greater the possible degree of profit or less, the lower the probability. In other words, in most instances, an “unlimited” profit or loss will not be realized in the extreme. A smaller (rather than a larger) profit or loss is more rational to assume as the likely outcome. This is all guesswork, of course, because whether options traders like it or not, the probability itself can never be calculated accurately. Being aware of the range of possibilities is the best anyone can expect.

Not only the percentage of outcome, but time itself, only add to the random variables of possible outcomes. This means that a small, medium or large level (of profit or loss) might be realized in a few hours, a day, several days, weeks or months. No matter how many applications of formulation are applied, there are many possibilities that, at lest, you can apply what you consider the most likely, more limited range.

This is the reality, but it is easy to overlook that by applying some flowed logic. For example, many traders believe that without considering other factors, profit or loss is a 50-50 proposition. Half will be profitable, and the other half will not. This is true for flipping a coin and expecting a 50-50 outcome of heads or tails, but options are not flat, two-sided items. They are not even tangible. The many variables include moneyness, time, volatility, and overall market conditions. Further complicating this, the random variables are not always equal in how they influence outcomes. Even if you can articulate all the matters influencing option profit or loss, how do you weight the elements at play?

Because there is no clear answer to this, every trader ends up having to make a few assumptions about the random variables. For example, you might assume the following:

  1. The closer to the money, the more reliable the assumption that profit or loss stand a 50-50 chance of being realized. The farther away, the loss likely the 50-50 outcome.
  2. The shorter the time to expiration, the greater the odds of loss due to time decay, and the less likely the odds of profit (for long positions). This assumption is flipped for short positions.
  3. The greater the volatility in both underlying and option, the more difficult it will be to predict outcomes on either side.

 

There is a degree of logic to these assumptions, but every options trader has experienced examples in which even the most conservative and logical assumption is betrayed by unexpected surprises and price movements. This is a reality, but it still does not explain why pricing models often do not reveal anything of value. Uncertainty defines options trading, and no pricing model based on current and historical observations can really predict the future.

It may be desirable to wish a pricing model exists that would do so, but it does not. Despite popular beliefs that pricing models are predictive, they never are, and this is the stark reality of trading, whether in options or other instruments. Models just predict future volatility and price based on current volatility and price. It’s like guessing that tomorrow’s temperature will be 72 because today’s high was 70 and it has risen by two degrees every day for the past week. Everyone knows this is not reliable, but that is precisely how pricing models are applied to predict. If we know the flaws in weather prediction based on “trends,” why not apply the same limitation to trading?

 

The great problem of trying to predict future option pricing is that options are not like other topics of analysis:

In physics or engineering, a theory predicts future values. In finance, you’re lucky if your model can predict the future sign correctly. So what’s the point? Models in finance, unlike those in physics, don’t predict the future; mostly they relate the present value of one security to another. In science, when you say a theory is right, you mean that it’s mathematically consistent and true – that is, it explains and predicts its corner of the universe. In finance, right is used to mean merely consistent: many models are right but usually none of them are true. [Derman, Emanuel (2007). Sophisticated vulgarity. Risk, 20(7), 93]


A comparison between several different trades or potential trades is rarely identical. This is where probability analysis becomes useful. It is possible, as an alternative to seeking a perfect pricing model, to develop a means for quantifying the likelihood of profitability when it is greater in one trade than in another. There is no guarantee of a positive outcome, but there is a better probability when the two estimates are vastly different.


This is not only the best any trader can hope for. It is a reliable system for making sound judgments and for overcoming the greatest random variable of all: the human element. Every trader is subject to biases not based on rational analysis, but on opinion, false assumption or irrational preferences. No one can realistically identify a means for ensuring profitable trades all the time, but  modeling can be useful in applying that desirable but rate aspect of trading: objective analysis.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Options Strategies for Small Accounts

    Ask a handful of traders what they deem a “small account” to be and you’ll get probably get a few different answers. For the sake of this article, we classify a small account as having less than $5,000. There’s a number of obstacles you run into trading a small account, like the options in certain underlyings being too expensive for you to trade, as one example.

     

    By Pat Crawley,

    • 0 comments
    • 112 views
  • 7 Things I Wish I Knew When I Started Trading

    Options Trading can be very exciting and rewarding. But you should not be trading options before learning at least some basic facts about options. Options are very different from stocks.  This article presents 7 basic options trading facts that every options trader should know. Don't start trading of you don't understand them.

    By Pat Crawley,

    • 0 comments
    • 226 views
  • How LEAPS Differ From Short-Term Options

    LEAPS stands for Long-Term Equity Anticipation Security. Which is just a long-dated option, typically referring to those with expirations more than a year out. There’s no technical difference between LEAPS and shorter-term options other than the expiration date. They’re traded on the same exchanges and have the same rules surrounding margin and whatnot.

    By Pat Crawley,

    • 0 comments
    • 275 views
  • What Is An Implied Volatility Crush

    IV (Implied Volatility) crush when the implied volatility of an option takes a nosedive shortly after the conclusion of a catalyst like an earnings report or corporate action. The uncertainty around a company’s earnings report (or other significant catalyst) drives option prices up in the lead-up to the announcement, and down following the announcement, once the uncertainty is gone.

    By Pat Crawley,

    • 0 comments
    • 223 views
  • Top features of NinjaSpread

    There are two main goals of the scanner: show you hidden opportunities and save a lot of time with automated scanning. Let’s see what the top features are and how NinjaSpread can help your trading life.

    By Gery,

    • 0 comments
    • 779 views
  • Wide, flat SPX Diagonal Spread

    I love to trade SPX diagonals, especially when IV skew is higher than usual and I get a wider range of break evens. I know that time spread break evens are “theoretical” because they are dependent on the IV skew of the front and back month’s IV that changes all the time.

    By Gery,

    • 0 comments
    • 721 views
  • How Investment Trading Can Help Grow Your Business

    When it comes to growing a business, there are many different options out there. For example, you could try traditional marketing methods or explore new and innovative ways of expanding your company. One such way is through investment trading.

    By Kim,

    • 0 comments
    • 1,359 views
  • 3 Tips To Use When Getting Into Asset Management

    Asset management has proven to be a fruitful career for more than a few professionals in recent decades, explaining why it’s attractive to finance professionals and students. Not only is it a financially rewarding career, but it’s one of the more interesting ones to pick.

    By Kim,

    • 0 comments
    • 681 views
  • Extrinsic Value vs. Intrinsic Value

    Options are distinctly different from stocks in that they’re derivatives of another asset. The entire value of an option contract depends on factors outside of itself--it’s all based on the price of its underlying asset. Options are highly mathematical in nature, and in some ways, we can quantify the precise value of an option using a model like Black-Scholes.

     

    By Pat Crawley,

    • 0 comments
    • 787 views
  • Comparing Iron Condor and Iron Butterfly

    Both the Iron Condor and Iron Butterfly are short-volatility option spreads. You'd use them to profit from situations where option prices imply a larger price move than your view of the market. These spreads are how traders profit from stocks that go nowhere.

     

    By Pat Crawley,

    • 0 comments
    • 809 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido