When it comes to trading, investors often believe they know what may happen going forward. Sometimes they’re right, and sometimes they’re wrong. Most people just buy and sell stock, leaving them at the mercy of the stock price. Here at tastytrade & dough, we do our best to avoid the guessing game and use more of a probabilities-based approach.
We may still have a directional assumption, but we always give ourselves a higher than 50% probability of being successful at order entry (the time we place our trade). Probabilities play a huge part in our decision-making process. Before we can jump into probability of touch, we first need to understand option probabilities around strike prices; specifically, the probability of being in the money (ITM).
Probability Of Being In The Money
All option strike prices have probabilities of being in the money, or in other words, having intrinsic value at expiration. These probabilities can and do change, as they are based on the implied volatility (IV) of the underlying. The expiration or days to expiration (DTE) are also a factor in these probabilities.
As we look at strike prices that are further and further out of the money (OTM), their probability of being in the money decreases. This makes perfect sense logically if we think about what must happen for these options to become in the money - the stock must move further and further from where it is currently, past the strike in question.
One important thing to remember is that the term “out of the money” will differ depending on whether we’re talking about calls or puts:
CALL = OTM strikes are above the stock price
PUT = OTM strikes are below the stock price
A call contract is the right to buy 100 shares of stock at a certain (strike) price, for a certain amount of time (expiration). Therefore, options with strike prices above the stock price are considered to be out of the money. The investor can buy shares in the market for a better price than they could by exercising the call option. Why would an investor buy shares at $105.00 when they can buy them for $100.00? They wouldn’t! That is why the $105.00 strike option would have no intrinsic value at expiration, and therefore it would be out of the money.
A put contract is the right to sell 100 shares of stock at a certain (strike) price, for a certain amount of time (expiration). Therefore, options with strike prices below the stock price would be considered out of the money. If an investor bought a put to hedge their stock, they would not exercise that put contract if they could sell their shares at a higher price in the market.
Adding probabilities to strike prices gives us an idea of how likely or unlikely an option is to expire ITM.
As option sellers, we want our options to expire OTM so we can keep the original credit we received for the trade. However, we also know that markets move and anything can happen. Why is this important? That’s where probability of touch comes into play.
Probability of Touch (POT)
Probability of touch is a measurement that gives us a rough idea of the probability of our strike being touched, or breached, by the stock price anytime during the trade’s lifetime. We have found that probability of touch works out to be around two times the probability of the option expiring in the money.
For example, if I sell a put that has a 20% probability of expiring in the money, it would tend to have a probability of touch of 40%.
While these are theoretical probabilities, the numbers are pretty eye-opening nonetheless. Understanding probability of touch is crucial not only for a better understanding of how markets move, but also in helping us understand that we may not need to panic if our option goes in the money.
The biggest takeaway for me is that even if I am selling a far OTM option, there is still a pretty good chance of the option going ITM at some point during its lifetime. If I have a firm understanding of this, it can ease my nerves if and when a trade goes ITM. That’s not to say that I’ll definitely hold an option into perpetuity; I’ll still evaluate where I am with each trade and reassess my assumption on the underlying. However, it is still a great tool to use as an options trader, and gives us an even deeper understanding of the probabilities we’re presented.
Probability of Touch RECAP
- POT is generally 2x prob. ITM
- POT can help us understand why our trades go ITM.
- POT can give us a better understanding of how a trade might play out from the time of trade entry to closing the trade.
Do you have more questions about probability of touch? Drop us a line at firstname.lastname@example.org or leave a comment below!