In today's video tutorial, I want to talk about the differences between the probability of ITM which is in the money versus the probability of a touch. We know the probabilities come in many different forms and today, we’ll discuss the specific differences between these two different ways of calculating the probability.
They are similar but different. We did mean to say that. They are very similar in nature, but they have a major, major difference in how you interpret them. First, let’s go through some descriptions and then we’ll look at some examples.
The first is that probability of ITM or in the money is the likelihood that a stock will trade up or down past your strike price that you’ve sold and stay at that level until expiration. Hence, this is the chance that you lose money on a trade.
If you are selling options out of the money and you don't want the stock to rally higher than your strike or fall lower than your strike, this probability indicator or calculation will tell you the exact likelihood of that happening or the likelihood that you lose on the trade.
Probability of touch is a little bit different. This is the likelihood that that same stock trades up or down to your strike price at some point between now and expiration, but doesn't expire at the same level.
Probability of touch is just basically is what it sounds like. It’s the likelihood that the stock comes up to or down to your strike price and just touches that level one-time but then retreats.
This is really important as we get deeper and deeper in the options pricing and why we are fans of letting trades go all the way to expiration. Here's a graph of the Qs which is the NASDAQ ETF that tracks the NASDAQ.
Currently, the Qs are trading at a little over 102 at the time of this recording, so if we wanted to sell an options strategy below the market…
In this case, we’ll just take the 98 strike price below the market right in the middle of the screen, and we could sell a naked put or a credit spread, anything that starts off with that first short strike being the 98.
You can see that the first arrow here, the probability of ITM, this is the probability exactly based on the entire trading history of the Qs and its current level of implied volatility, this is exactly the probability of the stock going from 102 and closing at expiration which is in 30 days, closing below 98.
This is incredibly powerful information because this tells you exactly the likelihood that you’re going to lose on the trade. There’s no guesswork involved here. It's given to you right on the trading platform and in the trading chain.
This likelihood is 25% which means that there is a 75% chance that you have a winning trade at the end of the day if you let it go all the way through expiration. That's the key here. You got to let it go all the way through expiration and more often than not, 75% of the time; you’re going to have a winning trade.
The next number over is the probability of touch. The probability of touch right now is 49.99%, so basically 50%. What this is telling you is that at some point between now and February expiration which is 30 days away, there is a 50% chance that the Qs trade down to 98 and just touch that level.
It doesn’t say anything about staying below that level. It just says that they’re going to go down here and they’re going to touch it.
This is really important as options traders because now we can visually see with hard data that there is almost two times the chance of an option being a losing trade at some point between now and expiration as there is if we just let it go all the way to expiration and become a winning trade.
In this case, every one out of two trades that you make will show a loss because the Qs will trade down to 98 and touch that level and if the stock is trading down to 98 which is your short strike, you’re going to have some paper loss in your account. There’s almost a 50% chance.
One in two trades that you make will show a loss sometime between now and expiration, but only 25% of those trades will actually stay a loss, and that is such a powerful number for you guys to understand and master because this is telling us that one out of two trades are going to show a loss, but only one out of four trades that we make are going to stay a loss.
When we go to the chart here of the Qs, you can see this is live data at the time of this recording that we have the stock trading at a little over 102 and our strike price is 98.
The probability of expiring or the probability of ITM is the likelihood that sometime before expiration which is this line right here, sometime before expiration, the Qs trade down to and stay below 98.
That's the probability of ITM, and that’s what we have, that’s our first number that we have that we went over. The probability of touch says at some point, the Qs might come down to 98, touch it, but not end there and that is the probability of touch.
This is really important because this gives you an idea of how many times you might hold a losing trade, but it might not end up being a losing trade.
This is why we also don't favor stop losses because if there is a 50% chance of touching and you have some stop loss set, you’re actually going to create more losing trades because the stock may touch that price point one out of two times, so you’ll end up losing half of the time.
That's why people always harp on the fact that options trading is so difficult because you can make high probability trades, and then they say that they end up losing the same amount. That’s because they’re using stop losses.
They don't understand the difference between the probability of being in the money or probability of profit and the probability of a touch. That’s a huge distinction.
The key takeaway here is that 50% of the time when you're holding or seeing a losing trade, it will come back around to become a profitable trade. This means that you’ve got to reduce your position size so that you can hold a losing trade all the way through expiration because it's not always going to be a winner.
We always talk about in football the team that wins at the end of the game is not always the team that’s ahead at half time. That never is the case.
You have to be diligent and believe enough to hold the trade all the way through expiration in which case; you have a higher percentage of win rate and a better chance of success.
As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below on the lesson page. Until next time, happy trading!