Probability of Profit
One of the reasons I feel options are the greatest thing ever invented, is the probability of making a profit in an options trade is much greater than the trading of any other asset.
When you buy or short a stock, what is the probability of making a profit?
I understand a trader may be using supply and demand, or support & resistance, or any other lagging technical indicator or oscillator that they feel will push the odds in their favor.
However, mathematically, when you buy a stock, your odds of making a profit are…50%. You buy a stock it goes up a penny you’re in the black, it goes down a penny, you’re in the red. 50/50.
That’s because stocks only have intrinsic value. The stock price is the stock price, because its…the stock price. And when you buy or short stock, you have to be right directionally to profit, and you will take a loss if wrong directionally.
If a stock, ADBE, is trading at $530 a share today, you can’t buy it at $520, or sell it at $540. Right? Of course you can place limit orders to buy it if it drops to $520, or to sell it if it rises to $540, but the stock would have to move for either of those limit orders to get filled.
But options have something no other asset has…extrinsic value. Options have a value above what the option is literally worth intrinsically, based on many factors, but predominantly based on time, on the number of days until the option expires. We call this time value.
So while a stock trading at $530, is intrinsically worth $530, and you can buy it or sell it only at $530, every optionable stock has options with strike prices above and below the current stock price.
So if your goal in a trade is to make a profit, option trading offers traders an additional way to profit separate from having to be right directionally.
If the premium of an option is in part based on how much time value the option premium has, in addition to the intrinsic value it has to be worth…what if all we did to look to profit was to sell the time value?
When you trade directionally you need the stock to move, and you need to be right on the direction it moves, however, when you sell options, you don’t need the stock to move, you just need the calendar to move, until it reaches the options expiration date.
I have no clue what ADBE will do in the future. If I knew where ADBE would be trading in 16 days, on September 8th…would I be here talking to you?!
But while I have no idea where ADBE will be on September 16th, I can absolutely guarantee that September 16th will get here. The calendar will move. The options will expire.
Call options above the current stock price, and put options below the current stock price have zero intrinsic value, their premium consists 100% of remaining time value. We call these out of the money options, because they are intrinsically worthless.
If we sell out of the money options, calls above the current stock price, or puts below the current stock price, that have no intrinsic value, all we’d be selling is sixteen days of time.
So, with ADBE trading today at $530, if we sold a 550 call, twenty points above current price for $6.45, the option would expire worthless at expiration if ADBE closed below $550.
If we sold a 550 call, we’d collect the premium, $645, and we’d get to keep the full premium if the option expires worthless at expiration.
Now what has to happen for a stock trading at $530 to stay under $550, so the call option expires worthless? Absolutely nothing…it’s already under $550. The stock can drop and be under $550, the stock can move sideways and remain under $550, and the stock can even go up nineteen points and still be under $550.
So while the directional trader needs ADBE to move, and to move up to profit, all the option trader, the call seller, needs is for the stock to stay below a level it’s already below!
You tell me…which trade has a greater probability of showing a profit?
This is why I love selling option premium when looking to profit!
There is certainly no guarantee ADBE will close at or below on September 16th. If the stock were to rally well above $550, the trade would be exposed to losses that could be significant. Any trade can go against you for any reason, no matter how good the trade looks at entry. Thus options should only be traded as part of a well thought out trading plan, with appropriate risk/reward parameters in place, and with appropriate position sizing based on a traders account size.