Why Selling Options Has Better Probability of Profit

Understanding Option Probabilities & Probability of Profit

Key Concepts:

• In the Money (ITM): An option with intrinsic value; profitable if exercised immediately.
• Out of the Money (OTM): An option without intrinsic value; not profitable if exercised immediately.
• At the Money (ATM): An option with a strike price close to the current stock price.
• Extrinsic Value: The portion of an option's premium reflecting time until expiration and volatility.
• Intrinsic Value: The profit an option would yield if exercised immediately.
• Probability of Expiring In the Money: The likelihood an option will have value at expiration.
• Probability of Expiring Out of the Money: The likelihood an option will have no value at expiration.
• Probability of Profit (POP): The likelihood a trade will yield at least a penny in profit at expiration.
• Break-Even Price: The stock price at expiration where a trade neither profits nor loses money.
• Black-Scholes Option Pricing Model: A mathematical model used to determine the theoretical price of European-style options.

I. Probability of an Option Expiring In or Out of the Money

The core concept revolves around understanding that an option will either expire in the money or out of the money – there’s no middle ground. These probabilities are fundamental to option trading and are derived from the Black-Scholes option pricing model, factoring in the expected future stock price at expiration.

Time Decay & Probability: Given a stock (XYZ) trading at $100, a put option with a $80 strike price expiring in 45 days has a higher probability of expiring in the money than the same put expiring in 10 days. This is because the longer time frame allows for more stock price movement, increasing the chance the stock falls below $80. The probability of expiring out of the money is simply the inverse: if an option has a 5% chance of being ITM, it has a 95% chance of being OTM.

Strike Price & Probability: Considering call options on XYZ at $100, a $110 strike call has a higher probability of expiring ITM than a $120 strike call. The $110 strike is closer to the current stock price, making it more likely to be exceeded by the time of expiration. Calculating the OTM probability involves subtracting the ITM probability from 100%. For example, if the $110 strike has an 80% chance of being OTM, the $120 strike might have a 95% chance.

Extrinsic Value Connection: As options move further OTM, their extrinsic value decreases, directly correlating with a decreasing probability of expiring ITM. At-the-money (ATM) strikes have the highest extrinsic value. This establishes a key relationship: increasing probability of expiring ITM corresponds to increasing extrinsic value. Conversely, as options slide OTM, both extrinsic value and the probability of expiring ITM decrease.

General Probability Ranges:

• OTM Options: 0-50% probability of expiring ITM.
• ATM Options: Approximately 50% probability of expiring ITM.
• ITM Options: 50-100% probability of expiring ITM.
• The closer to expiration, the more these percentages converge towards 0% (OTM) or 100% (ITM).

II. Probability of Profit (POP) – A More Realistic Metric

Probability of Profit (POP) is defined as the probability that a trade will yield at least one penny in profit at expiration. It’s closely tied to the break-even price of the trade and considers the expected stock price movement during the option's lifespan. A higher POP indicates a greater likelihood of a profitable trade.

Buying vs. Selling Options & POP:

• Buying Options (Long): POP is lower than the ITM probability. This is because the premium paid for the option (a debit) represents extrinsic value that must be overcome by stock price movement just to break even. For example, a long $80 put purchased for $5 requires the stock to fall to $75 just to break even. The ITM percentage at $80 might be 50%, but the POP will be lower, around 40%, reflecting the need for a larger price move.
• Selling Options (Short): POP is higher than the OTM probability. The premium received for selling the option (a credit) improves the break-even price. Selling the $80 put for $5 creates a credit that offsets potential losses. Even if the stock falls to $75 at expiration, the $5 credit can result in a wash, or even a profit. The OTM percentage might be 50%, but the POP could be 60% due to the credit received.

TastyLive’s Approach: TastyLive prioritizes selling options due to the higher POP and the ability to profit even if directionally incorrect. They aim for trades with a POP exceeding 50%, increasing the likelihood of long-term profitability. Combining short options with stock ownership (e.g., selling a call against 100 shares) further enhances the POP.

III. Key Takeaways & Considerations

• Probabilities are not guarantees: They represent likelihoods, not certainties.
• POP is a more practical metric than ITM/OTM probability: It accounts for the cost or credit associated with the trade.
• Time and strike price significantly impact probabilities: Longer timeframes and closer strike prices increase the probability of expiring ITM.
• Extrinsic value is directly linked to probability: Higher extrinsic value corresponds to a higher probability of expiring ITM.
• Selling options generally offers a higher POP: But carries greater risk.
• Focus on trades with a POP > 50%: To improve long-term win rates.

Important Note: The percentages discussed (e.g., 40%, 60%) are illustrative examples and will vary based on market conditions, volatility, and other factors. The video emphasizes understanding the relationship between these concepts rather than memorizing specific numbers.