20 Replies to “Options Trading Probabilities Explained – POP vs Prob ITM vs Prob OTM vs P50…”

  1. Great article! Not often do I find a simple explanation for ITM and OTM. What I was most fascinated about though was the P50, I had never heard of that?

    P50 may be more toward my trading style since I do like having more winning than losing trades for psychological reasons. I find that more frequent, smaller wins allows me to better abide my trading rules and stick to the plan.

    Although, I’ve had to re-adjust a lot of my back testing to suit my trading style with more wins and less losses, I’m more comfortable in my own trading skin.

    Tastyworks is a platform I’d have to check out for this reason, do you recommend them for anything else other than P50?

    Cheers Rohan

    1. Thanks for the comment Rohan! 

      I absolutely recommend tastyworks for something else than the simple P50 feature. The P50 feature is just one of many examples of their great platform. I use tastyworks for all my trading because they are so great.

      If you want to learn more about tastyworks’ features and why I recommend them, make sure to read my tastyworks review.

  2. Hi Louis, Thanks for this detailed and thorough article. I feel I have a much better understanding of option trading probabilities. I also appreciate the section on the Probability of Touch, which is a new concept for me.

    One thing I am learning more about is trading options around earnings. I am curious if you can speak to how earnings seasons can affect the ITM and OTM probabilities for stocks. Could you look at the probabilities, for example, and get a sense of the direction that a stock cold move prior to earnings?

    Thanks for any insights you can provide!

    1. Thanks for the comment Laura.

      As you know from my article about trading options on earnings, implied volatility (IV) usually increases before an earnings announcement. An increase in IV means that the market expects a big upcoming move. This will also impact the probability of ITM/OTM. If a big move is expected, the probability that an option will expire OTM decreases and simultaneously the probability that an option will expire ITM increases.

      Hopefully, this makes sense to you. If a price will likely move a lot soon, it makes sense that options have a higher probability of expiring ITM than if no big move is expected. 

      When setting up an earnings trades, you could definitely use these different probabilities. Ideally, you should set up a strategy that hasn’t a very low probability of profit. 

      I don’t really know a way to use probabilities to predict how a stock will react to earnings though.

      I hope this could help you out.

      1. Hello Louis,

        I’ve lost tens of thousands of dollars just buy buying calls or puts right before earnings and either I chose the wrong strike or there was no up move at all

        I always thought it’s best to sell premiums via credit spreads during earnings because the IV is much higher than the underlying’s HV

        Please give me your thoughts on this. Thanks.

        Lawrence

        1. Thanks for your comment. It is correct that IV usually rises leading up to earnings. On earnings, however, IV tends to drop quite a lot which is great for overall short premium strategies. Credit spreads are a way of trying to profit from this. However, there are other strategies that can profit much more from this IV drop than credit spreads. Furthermore, you take a directional bet with a credit spread which can be quite risky on earnings as prices often tend to move a lot after an earnings announcement. So when you get caught on the wrong side, the IV crush won’t be enough to compensate the losses incurred through the price move of the underlying asset.
          I have an article on how to trade options on earnings. In it, I go over this IV drop and suitable strategies much more thoroughly. Just note that this strategy can be quite risky.
          Hopefully, this helps.

  3. Hi Louis

    On Sky View Trading recommend we use 30% Prob ITM that equal to 60% Prob of Touch, right? That gives good Credit but may need adjustment if the price against us. So I get confused which one to choose 30% or 42% Prob ITM? As 84% POP sounds good to trade. Thanks

    1. Hi Harry,
      If a strike has a 30% probability of ITM, it should have a probability of touch of about 60%. So yes, you are right.
      As to which probability is best, I can’t give you a concrete answer. It really depends on the situation and your personal preferences. In my opinion, neither 30% or 42% is better. It just really depends. But as long as you collect enough credit and have a decent probability of success, you can’t really go wrong.

  4. Hi Louis,

    Because the Prob ITM changes throughout the option’s life cycle, how do we know that we are getting in at the right probability ITM. i.e. I sell at a 30% Prob ITM, so I should have a 70% chance the option expiring worthless by expiration. But the next day the prob ITM changes to 50% and never goes back to 70%. So is the 70% Prob ITM I entered not valid anymore, and it is now a 50% prob ITM trade?

    Thank you

    1. Hi Tim,
      I’ll use your example to clarify this. If the probability of ITM changes from 30% to 50%, it doesn’t make the original 30% probability of ITM invalid. At the time that you opened your position, the option had a 30% probability of expiring ITM. Now it changed, but that shouldn’t disturb you too much.
      In terms of underlying price, this situation probably looked something like this: you sold a call option $10 above the current price of the underlying. One day later, the underlying’s price moves up by $5, thus the option isn’t as far OTM anymore and therefore, the probability of ITM increased.
      So now the question is how do we know if we got in at the right price (of the underlying)? The answer is, we don’t. But we try to open as favorable positions as possible.

      Something like this will happen very often as prices tend to swing around a lot. If they move in one direction, the probability of ITM will increase and in the other direction it will decrease. But as long as you open your trade with an initial good probability of success and otherwise favorable setup, you are doing everything right.
      I hope this helps.

      1. Wow, thank you for clarifying, that helps. So I guess this topic kind of falls into portfolio management and trying to stay ‘delta neutral.’ One strategy would be to stick to the probabilities and let the stock price move around until expiration and hope that the probabilities work out, and that we end with a win. The other would be to adjust the trade. When would you recommend to adjust the trade and realize that the initial entry will not work out, and when do you just hold the position until expiration?

        Thanks again.

        1. Hi Tim,
          The specifics vary from trade to trade. However, I recommend having a clear plan for when to adjust before you open a trade. I actually have an entire article dedicated to adjusting option strategies. I recommend checking it out for a thorough answer. If you still have any questions left afterwards, let me know.

  5. I’m a bit confused. How can the probability of achieving 50% profit ($108) be higher than the probability of profit (achieving $0.01 profit)? If POP is 64% how can setting a higher bar (50%) have a higher chance?

    1. Hi Matt,
      Thank you for your question. POP is the probability of achieving a profit at expiration, whereas P50 is the probability of achieving 50% of max profit anytime between now and the expiration date. It is likelier that a position will temporarily achieve 50% of max profit sometime in the future than that the same position will be profitable on a very specific day in the future. In simple terms, P50 has a lot more chances than POP.
      I hope this makes sense. Otherwise, definitely let me know.

  6. Hi Louis,

    Mind if I ask a question? On this trade the maximum profit is $214 and the maximum loss is $286. We don’t know what the odds are of taking the maximum profit because POP is just that we are in profit (not max profit), but with tastyworks we can know the probability of 50% of max profit, which is $107 right? The probability of hitting P50 is 73%. Now if we assume that the probability of not hitting P50 and expiring at max loss is the other side of this probability (which I don’t think it is) so 27% then we can run the calculation of whether this trade would be profitable over many instances as 0.5 x $214 = $107 x 0.73 = $78.11. Which means that run over a large number of instances we would take on average $78.11 per trade. However, we will lose $286 x 0.27 = $77.22 on average per trade. So we have a slight edge on this trade even assuming that we hit maximum loss the 23% of the time we don’t touch P50. Am I calculating this correctly? And am I correct in saying that the 23% of the time that we don’t hit P50 we will not suffer the maximum loss every time so actually our edge is better than my above calculation?

    Thanks a lot, love the site BTW

    1. Hi Ashley,
      Thanks for your comment. Firstly, I just want to say that all these probabilities are purely theoretical. It’s certainly a good idea to calculate things such as expected value but you should always remember that this shouldn’t be more than a rough guideline.
      As far as I can see, your calculations seem to be correct.
      Let me know if you have any other questions or comments.

  7. Hi Louis,
    When trading option strategies, should one let the probabilities play out until expiration? If one does planned adjustments, it may affect probability of winning over large number of trades, and thus create negative expectancy. What are your thoughts or any backtest results i n this aspect?
    Thanks very much for this informative blog.
    Manish

    1. Hi Manish,
      Thanks for the question. You are certainly right in that adjusting your trades will have an effect on the expected return. This effect, however, doesn’t necessarily have to be negative. Tastytrade has done a bunch of studies on adjusting and closing trades early. As long as the adjustment doesn’t increase your risk and dramatically decrease your probability of profit, it likely will have a positive effect on your expected return.
      Tastytrade’s studies have also mostly shown that aiming for a conservative profit target such as 50% outperforms holding till expiration. This also makes sense since closing trades early decreases the time spent in each trade. This allows you to make more trades in the same amount of time with a higher win rate.
      I hope this answers your question.

  8. Hi Louis –
    Thanks for this site. It’s terrific. I’m a novice, and appreciate the way you explain things.

    Question regarding the Probability of Touch. If PoT is double the PoITM (one example above was 42% ITM, making PoT 84%), why wouldn’t the owner of the option sell it at the point it touched the strike price (before expiration)? You refer to this a “paper” loss, but wouldn’t it be a real loss if the option owner sold it?

    I’m sure I’m missing something – please let me know what it is!

    Thanks again,
    Tom

    1. Hi and thanks for the comment.
      The P&L of the option position when the underlying touches its strike price depends on the entry price of that position. Sometimes, it will be a profit and other times it will be a loss. But if there still is enough time left, it might not make sense to close the position from a risk/reward standpoint. If, for instance, the profit is only $5 and the risk on the trade is $200, it doesn’t make sense to close the trade at such a small profit compared to the risk. Even with an 85% win rate, this would be a losing strategy in the long run.
      I hope this answers your question.

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