Lesson Overview

Option Probability Curve

We are all visual learns and in this video I'll show you a simple but powerful indicator to help you master the option probabilities with the "Probability Curve".

This very cool tool helps you project where a stock will or will not go within a give confidence range is truly eye-opening. And as traders we can use this data to build option strategies to profit from these range bound markets.

More Discussion

Was This Helpful? Add Comments/Questions

  • Correct everything that’s calculated on the graph is always “at that moment” so if IV increases or the stock moves then everything is re-calculated on the fly.

  • RKK

    Excellent Quality Instruction as you also seem to enjoy what you are teaching. Using the Apple example provided, if an option position is taken (i.e. sell a call above the 68% cone), isn’t the probability of success approx 84%? This would equate to the 50% of the low side of the normal distribution plus the 34% representing the cone?

    • Yes depending on where the strike price and break-even is you’d have an 84% chance of success.

    • Nisheeth

      Yep, for short call that’s at a strike price 1SD above mean your probability of success is ~84% .

      Probability that underlying stock/ETF remains within +/- 1SD is 68%. This can be used for iron condor / strangle strategy.

  • Marcony

    Hi Kirk,

    Excellent video, unfortunately i don’t use ToS, currently trading with OptionsHouse. I’m curious to know, in your opinion how is this indicator different than Bollinger Bands? Thanks!

    • Different in many ways because it projects expected ranges. Bollinger games expand and contract.

    • Kingfishers

      OH’s TradeLab is great. It is getting more similar to TOS. I love their Analyze Snapshot and Spectral Analysis which can help with analyzing your trades and future trades! I’m using both tradeLAB and TOS and TDA is eating me alive with their high commissions and fees! I’m keeping my large account at OH!

  • Chuck Anderson

    Wow another great feature of TOS, would not have known about otherwise (Kirk, you just have so many gems scattered around, it is as much fun looking for them as it is productive when I can put one to use).. This can be used not only for deciding how/where to enter a trade either. You can place a trade then come back to the chart in 2 weeks e.g. and see if the cone(s) have shifted (widened of narrowed), ponder whether your trade will stay OTM, or if you need to make an adjustment, or look again in a week, etc.

Show Video Transcript +

In this video tutorial just for you guys, I wanted to go over a little bit about mastering the probability curve and the market randomness.

And the reason I want to cover this in-depth in this video is that I do think it's one of the foundational elements to understanding and grasping the logic behind why we do what we do with options trading.

It’s not just whimsical; we’re not going out here like a bunch of cowboys on a rodeo horse and shooting from the hip and picking trades and making bets. It's got to be a very logical and systematic way of doing things.

And part of that basis for understanding why we do what we do, why we choose the strategies we choose, why we price the trades the way that we price them, why we make the adjustments that we do, is because we have to understand this basis of market randomness or this probability curve.

And I have up here a slide from one of the videos that we did in our 4-part course on the website. And if you’ve seen it before, you’ll understand it again.

But the slide that I have up here is a normal distribution graph and it’s this is normal probability distribution graph that basically says that generally, if we have a very random market, (which we know the market is 100% random) then we’re going to get a pretty normal distribution of movement in the underlying stock over a given period of time.

We’re going to get the movement that is generally or about 68% of the time within a one-standard deviation of where the market is right now. And then you go further out from there and out from there, and we have these tails on either end.

But applying that to the stock market is a little bit different, and some people don't have the insight or at least the vision to understand how this translates to stocks, so what we do is we then take a look at a chart like this where we take this same graph and turn it sideways.

And that's basically what we have when we look at really any stock chart, are we have a normal distribution graph going out into the future. As we go further and further out into the future, then the likelihood of the stock making a bigger and bigger move obviously increases because we move further and further out, it’s got more time to make that movement.

That's where we get this distribution graph from. Now, what I want to show you guys here in this video is how you can get that graph and a bunch of different graphs just like it on your actual charts, at least on the Thinkorswim platform.

I can’t speak for the other platforms, but at least on Thinkorswim, I can show you guys exactly how to get this distribution graph, so you can visually see where the stock may or may not go within a certain range of confidence or within a confidence range.

Let's head on over to Thinkorswim. We’re going to use Apple as an example because it's highly traded, very liquid. And today as we close out the end of the month in May as I’m doing this video, the market is still active in trading and Apple you can see has had a huge rally.

At this point, we don’t know where Apple is going to go. You can make your bets, whether you’re bullish or bearish or whatever the case is. But we do know that Apple is very highly traded and very liquid.

Now, if we want to project out into the future and get that same type of distribution graph or we have that big wave or those big lines that show us where in the future Apple might go, we can do that pretty easily in our platform by adding a probability curve or a projection cone.

What I think is what they call them now. We’re going to go here, and we’re going to add a study. And I’m going to go to “add studies” and go to… I’m going to move this over, so you guys can see it. And “probability of expiring cone.”

They always add this as a new a feature. The study that you want to add is called “the probability of expiring cone, ” and it takes into account the 68 percentile, so that basic one-standard deviation that we were talking about.

I’m just going to apply this to the chart right now, and you can see it here on the chart. Now that we have this probability cone that's setup for us on this chart… And I’m just cutting off a little bit to show you guys.

But this probability chart now shows you within a 68% range where Apple might trade 68% of the time between now and all of these different expirations in the future. Remember that these dotted red lines on the charts are all expiration dates in the future, June expiration, July, August, September, etc.

We can vertically show you at what point in the future Apple may or may not trade within that range. Now, it’s pretty obvious that that range is going to continue to expand both on the topside and the bottom side as we get further and further out into the future because the stock has more time to move.

Right now, we’re about 21 days until expiration in June, but the stock has more time to move if we traded something in July, so we want to use those figures versus the June figures.

Now, what this is showing you is that there is a 68% chance because that's what we have, the cone setup right now, 68th probability level.

There is a 68% chance that from Apple today, from where it’s trading today at 644, that Apple trades within this range between now and June expiration and that range are 595 on the lower side, so 595 down here and 668 on the upper side. Again, a 68% chance or more or less a 70% chance that Apple trades between 668 and 595 between now and June expiration.

You can see how you can visually just project that on the chart and we get almost the same identical look in our charts that we have here in the slide that we did where it’s just something I threw together just to get your minds thinking about these probability graphs on the actual stock chart.

Now, if we go out further and we trade July options, then you can see that within that same 68% confidence range that we had numbers that are further out.

It's saying that between now and July, there’s a 68% chance that Apple is going to be between 685 on the topside and 574 on the bottom side. Powerful stuff. And I’m sure you’re sitting there going, “This is really cool. I’ve never seen this before.”

Now, what we can do and what I like to do with some of my charts is add a couple of these studies and give you some real perspective on probability ranges if you’re not familiar with them.

I’m going to go in here, and I’m going to add just a couple more just to show you where some of them can be. I’m going to take this one at 68, I’m going to change one of these up here, and I’m going to make this an 80% confidence level, and the last one, I'm going to make a 90% confidence level, so where my probability range is.

You can see on the chart now, I’ll have 68% which is a one-standard deviation, I’ll have an 80% confidence, and then I’ll have a 90% confidence. If you want to trade with better than 90% chance of success, then you want to trade outside of that range.

Let’s hit “apply” and “okay” once I turn off my highlighter. Alright, here we go. Here are our three probability cones that we now have on the chart, and you can see visually on here that these cones project into the future and they get wider and wider.

Now remember, the lower probability cone is going to be on the inside. This cone on the inside here, this is the same one that we’re dealing with before, this is the 68% probability range. It’s going to give us a lower range of conference.

Now, if we want to be even more sure about the trade and say, “I want to trade at the 80% probability level, meaning I want to trade with 80% chance of success,” then we want to trade outside of that range and just a little bit further on either end.

Now, we have that other probability cone that’s getting out a little bit further. And again, just going one other degree, if we want to say, “I want to trade with 90% chance of success, so I want to be sure that if I’m selling a spread that I have real good odds of success.”

Then we go even further out on the distribution graph here, and it gives us a wider range and basically, tells us to move our strikes even further out. A very, very powerful tool and all of the numbers are right here.

It gives you all of the numbers for each expiration level on both June and July or whatever month you’re looking at this right now. It's a powerful tool to use.

Before we go away from Apple, I just want to throw up another example just to use some other stocks as an example. Here's Chipotle.

A little bit more volatility in Chipotle right now and you can see that visually on the chart because it’s at the 43rd percentile and implied volatility which was higher than where Apple was.

But you can see these same projection graphs or these expiration cones go out onto the chart right now, so we have the same type of logic working here that we had with Apple with the 68.

This one is the 68, and this one is the 80, and this one is the 90, have the same type of logic that’s working on this chart. You didn't have to change a thing once you add these studies to your chart.

Where you want to use this in your trading is you want to take a look at these numbers and just make sure that if you're trading with a 70% chance of success, then you want to be selling something above these levels. You want to be selling something above that level or below that level.

And this is just really something to give you a quick reference. You can still check the probability of each strike right in the trade tab. And we’ve gone over that some times.

But these projection cones are a good tool to use because most of us are visual learners, so if we can visually see where the stock may or may not be, then that actually might help us make a trade or not make a trade that we shouldn’t be making going on into the future.

As always, I hope you guys enjoy these videos. Continue to ask a bunch of questions, add your comments right to the main area of the membership side. And happy trading!

eBook Download

The "Ultimate" Options Guide

Ultimate Options Strategy Guide

The step-by-step guide on how to set up each of the top 18+ options strategies we trade to generate monthly income. Read the whole strategy guide in less than 30 mins and have it forever to reference.

Download PDF

Join More Than 47,345 Members

Membership is always free & you can upgrade anytime to unlock our live trades.