Option Trading Review: What is high probability trading?

A popular form of options trading is selling options, which gives you cash from the sale, but in this sale you hope you never have to deliver the item. You are selling an option to another trader, which gives them the write to buy a stick or other asset, at a certain price, on a certain day and in groups of 100, if it’s a stock. Your using math and probabilities to increase your chance of a successful trade. It sounds easy, but what does it really mean? That’s what I will discus today.

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Background
To understand the you need to understand these terms.

“Premium”
In exchange for the rights conferred by the option, the option buyer has to pay the option seller a premium for carrying the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.

“Expiration Date”
Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration date and month is specified for each option contract.

Call Option
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.

Put Option
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.

Out-of-the-Money (OTM)
Calls are out-of-the-money when their strike price is above the market price of the underlying asset.
Puts are out-of-the-money when their strike price is below the market price of the underlying asset.
Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only time value. Out-of-the-money options are cheaper than in-the-money options as they possess greater likelihood of expiring worthless.

Theta
Theta is a measure of the rate of decline in the value of an option due to the passage of time.

When your a seller, theta is your friend, I.e. it decreases the value of the option you sold rapidly and at a certain point you could buy the option back and get to keep a big percentage of the premium and be released from your obligation.

Explanation of high probability trading
The seller of an option is hoping the underlying stock’s price never hits the strike price and the buyer of the option is hoping the stock reaches and surpasses the strike price.
The option premium for any strike price is calculated based on the probability of the stock reaching that price, which in turn defines the risk of the buyer and the seller, and the amount of risk determines the price.

So for example, in terms of probabilities if you pick as a strike price the current market value of the stock there’s a 50% chance it will close at that price when the option expires. That may come as a surprise, but statistically speaking when you look at short term of 30-60 days, that’s the calculated probability, backed by Nobel Prize for Economics math formulas. Now as you move away from the market price you are following a bell shaped curve of probabilities. The higher the price or the lower the price, the less likely it becomes that the stock will be at that price on Option expiration date. Each stick has different bell shaped curves in that the one standard deviation move could be one dollar for stock A but ten dollars for stock B. So you should review the price probability curve for each stock before trading.

Now when we say high probability or low probability trading we refer to the probability of a successful trade, defined as profiting one penny. In high probability trading you are trading in the 80% or greater probability zone, which corresponds to an 80% chance of successful trade. Those are the words, let’s look at an example.

Example of high probability trade

You wish to sell calls on Apple.
Apple market price is $100.
Apple call options with a strike price of $105 and an expiration December 14th are in the 55% and have a premium of $7.00.
Apple call options with a strike price of $110 and an expiration December 14th are in the 85% and have a premium of $1.00.
You decide to go with a high probability trade at $110 Strike price and sell one contract for 1$ per share or $100 total.
You could have sold the $115 Strike price at the 95th percentile, but the premium was 35 cents.

Now you have sold someone the right to buy 100 shares of Apple from you at $110.
If they exercise their option you must go into the market and buy Apple for market price and sell for your strike price.
That strike for Apple, this month and with that expiration was 85th percentile.
That means there’s a 85% probability that Apple won’t reach that price by the Options expiration date and a 15% probability that it will.
The high probability it won’t reach that price means your premium is smaller then a 75% Strike price, but your risk is also smaller. You have a 85% probability of success and a 15% probability of failure. You are the seller, so for you this is a high probability trade. You could make more money selling strike prices closer to the Apple current market price, but each step closer increases the probability of the stock closing at that price and decreases your probability of success.
This is called a high probability trade, because the mathematical probabilities are high at 85% on your side. Some people only trade high probabilities because they have such a good chance of winning.

✍️ written by Shortsegments