Probabilities are the only proven way to consistently trade profitably. We can calculate the probability of an option closing ITM and we can also calculate its probability of being touched. Knowing the likelihood a stock will touch our short strike is one thing. However, because we are collecting a credit for the options, we also can look at the probability of a stock touching our breakeven price.
We recently ran a study looking at short strangles in SPX. We simulated selling both the 16 delta put and call and then managing those trades once they reached 50% of their maximum profit potential versus holding those trades until expiration. We then compared the results both when the stock touched our short strikes and when the stock touched our breakeven price.
A 16 delta option has about about a 16% chance of expiring in-the-money (ITM). The probability of that option being touched at some point before expiration is 32%, or two times its delta. Therefore, a short strangle comprised of a 16 delta put and 16 delta call has a 64% probability of either the put or call being touched. What we observed, however, was something different.
In our study, the put was actually touched 18% of the time versus the 32% we expected. The short call was touched 30% of the time, just under the 32% we expected. In total, our short strikes were touched 48% of the time, well under the 64% anticipated. But that was not all we learned.
Of those 48% of the trades where a strike was touched, 54% would have been managed before that touch occurred. In other words, we would have closed out those trades at a profit before SPX ever reached our short put or call.
Taking things a step further, we also looked at the number of times SPX touched our breakeven prices. 33% of the time our breakeven price was touched (15% on the short put and 18% on the short call). Again, however, 48% of those trades would have been managed before having its breakeven price tested.
Trades we did not manage at 50% ended up with a negative P/L, emphasizing the importance of actively managing trades.
Volatility overstates pretty much everything when it comes to trading, including probability of expiring ITM and probability of touch. That is why we look to sell premium: it is overpriced. The odds favor us. We sell premium and then actively manage trades because data has shown time and again, that is how to make money.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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