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Calculating the Probability of Touching

Sebencapital

Published
22/12/23
Calculating the Probability of Touching

For beginners in options trading, getting acquainted with option calculators is crucial. These calculators handle calculations involving factors like delta, gamma, theta, vega, and rho, while also determining the theoretical value of an option given specific inputs. These inputs typically include the stock price, strike price, time until option expiration, interest rates, dividends (if applicable), option type (call or put), and an estimated volatility of the underlying stock. Understanding and utilizing these tools can assist in making informed decisions when trading options.

Key Takeaways

  • Probability of Touching (POT) calculators are helpful tools for option traders. They provide valuable insights by indicating the likelihood of an option reaching a profitable state (in the money). These calculators offer information about the chances of an option moving into a favorable position, aiding traders in making informed decisions when dealing with options.
  • When you have an in-the-money (ITM) option, the probability of touching represents the likelihood that the option might shift from being in a profitable position to moving out of that profitable zone, turning into an out-of-the-money (OTM) option. Understanding this probability helps traders anticipate the chances of their ITM options moving into a less favorable state, aiding in decision-making when managing options.
  • If you have an out-of-the-money (OTM) option, the probability of touching signifies the likelihood that this option might shift from being unprofitable to moving into a profitable state, known as in-the-money (ITM). Understanding this probability helps traders anticipate the chances of their OTM options becoming profitable, aiding in decision-making when dealing with options.

Probability of Touching Calculator

This calculator is incredibly useful for all levels of options traders, including seasoned ones, and goes by different names like "Probability of Touching Calculator" or "Stock Price Probability Calculator." You can ask your broker if they offer such a tool for your use.

Its main purpose is to answer a fundamental question: If I hold a specific option for a set number of days, what are the odds that the stock price will touch or reach the strike price?

For sellers of options: If you specify how long you intend to hold the short position (you're not obligated to hold until expiration), this calculator predicts the probability that the stock price will hit the strike price at least once during that period. For instance, if it shows a 15 percent probability, then there's an 85 percent chance that the option will expire without reaching the money-making status.

Note: This isn't the same as the probability of the option expiring worthless. Sometimes an option moves into profitable territory and then back out, expiring worthless. The calculator disregards these instances. As a close estimate, the chance of the stock price touching the strike price is roughly double the chance of the option expiring worthless. This is often around twice the option's Delta at the time of the trade.

For buyers of options: If you specify how long you plan to hold the long option position (you might exit before expiration), the calculator offers an approximate probability that the stock price will hit the strike price at least once during your chosen holding period.

If you have an in-the-money (ITM) option, the probability of touching reflects the chance that the option might move out of a profitable state. For out-of-the-money (OTM) options, it indicates the probability of the option moving into a profitable state.

Other Strategies

When you're involved in trading options strategies that involve multiple components, often called spreads, it means there's more than one option at play. For instance, in a basic butterfly spread, you'll own and deal with two distinct options.

Example:

Buy 1 XYZ Oct 100 call
Sell 2 XYZ Oct 105 call
Buy 1 XYZ Oct 110 call

When trading a spread strategy where the stock price's movement beyond certain levels affects its value, like when it goes below ₹100 or above ₹110, the spread becomes less valuable or worthless if the stock doesn't stay between these levels by expiration. It's crucial for traders to understand the likelihood of the stock touching either ₹100 or ₹110 during the expected holding period. A Probability of Touching Calculator helps by showing the chances that the stock will reach these specific prices. For strategies like the iron condor, knowing the probabilities of touching different strike prices is essential for effective risk management.

Choosing the Holding Period

You can use the calculator to figure out the best duration to hold onto a position. Adjusting the "days" in the calculator shows how the chance of touching specific prices changes over time. By doing this calculation daily with the current stock price and potential gains or losses, you can decide whether it's worthwhile to continue holding onto the position or if it's better to make a move. This method helps in evaluating whether it's advantageous to maintain the position based on evolving stock prices and potential profits or losses.


Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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