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Financial Literacy

Using a Probability Calculator: Know Your Trade’s Exact Chance of Success Up Front

Using a Probability Calculator – Know Your Trade’s Exact Chance of Success Up Front

By Lee Lowell, Advisory Panelist
Thursday, June 30, 2005: Issue #221

I like to use as many tools as possible when trading options, and there’s one tool I always check before actually making the trade.

That tool is called a “probability calculator.”

A probability calculator will give you the odds of the stock price being above or below your option position’s breakeven point (or any point, for that matter) based on all the factors that affect your option at that moment in time. The three most important factors are:

  • Price of the underlying security
  • Time until expiration
  • Volatility

Here’s a snapshot sample of a probability calculator that I use, and that you can use for free through OptionVue:

Use our probability calculator

As some of you might know already, I spend lots of my time watching the Walt Disney Co. (DIS). As I live in Orlando, FL, that company consumes every inch of the area. So, it’s hard not to be influenced by Mickey Mouse.

The probability calculator above shows me the chances of whether DIS will get down to my breakeven area of $22.40/share by option expiration in August. As I like to sell put options on DIS, and on this particular trade, my breakeven price of my short option (where I would start to lose money on the trade) is $22.40/share.

A 96% Chance at Success With DIS

Based on the current price of DIS – with 54 days remaining until August options expiration, and with a volatility estimate of 20% – the probability calculator is telling me that DIS has only a 3.4% chance of finishing below $22.40/share by the expiration on August 19, 2005. This figure is seen in the box labeled “Finishing below lowest target.”

So this means that I have a better than 96% chance of having a successful trade. I like that.

To use the calculator, you must type in each of the parameters in the top section. Then hit the “GO!” button. Not only does the calculator give the probability of the stock being at your breakeven point at expiration, it also gives you the probability of the stock EVER hitting your price at sometime during the life of the trade.

In my particular case, the chance of DIS ever hitting my breakeven point is only 13.6%. Still a great probability for me to take the short put option position.

Using the Probability Calculator for Straddles

The calculator is also good for those who like to trade straddles, as it will give you the chances of the stock moving either above or below the two breakeven points by options expiration, or any time during the trade.

Look at the probability calculator example below:

Probability calculator data

In this case, we’re buying an October $25 straddle (buying an October $25 call and $25 put together), for a total price of $2.40 per straddle.

To find our breakeven points, we first add and then subtract $2.40 from the current price of $25.63, and plug those numbers into the top section and hit GO!

The bottom section shows us that we have a 16.1% chance of DIS finishing at our lower breakeven, or a 25.1% chance of DIS finishing above $28.

Watching for the Breakeven Point

What you’ll notice about this particular trade, as is most often the case with straddles, is that the stock can hit your breakeven points at some time during the trade.

That’s when you either have to cash out or make an adjustment. The probability calculator is telling us that there is a 63.8% chance and a 91.7% chance that DIS will hit one of our breakeven points sometime during the life of the trade. That’s when you have to make your move.

These aren’t some hocus-pocus numbers. Probability is the basis of all options trading. Will the underlying stock get to our price or not? If so, will it do it in the time allotted, or will the level of volatility hold it back? That’s what the calculator will do for you. It takes all your input parameters and gives you your chances of being successful (or not successful) at that moment in time.

Every day, the figures will be different. DIS will be at a different price. There will be one less day to expiration, and the volatility assumption might change. But the use is still the same. It’s giving you an idea of your chances of winning based on your assumptions.

So, the next time you want to make an options trade, use a great tool such as our probability calculator to determine the chance of success.

Good trading,

Lee


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