Index Option Trading Explained

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What is an Index Option?

Like stock options, index option prices rise or fall based on several factors, like the value of the underlying security, strike price, volatility, time until expiration, interest rates and dividends. But there are five important ways index options differ from stock options, and it’s important to understand these differences before you can start trading index options.

Difference 1: Multiple underlying stocks vs. a single underlying stock

Whereas stock options are based on a single company’s stock, index options are based on a basket of stocks representing either a broad or a narrow band of the overall market.

Narrow-based indexes are based on specific sectors like semiconductors or the financial industry, and tend to be composed of relatively few stocks. Broad-based indexes have many different industries represented by their component companies. But that doesn’t necessarily mean there are a ton of stocks that make up a particular broad index.

For instance, the Dow Jones Industrial Average is a broad-based index that’s only composed of 30 stocks, but it still represents a broad range of sectors. As you would expect, however, other broad-based indexes are indeed made up of many different stocks. The S&P 500 is a good example of that.

Difference 2: Settlement Method

When stock options are exercised, the underlying stock is required to change hands. But index options are settle in cash instead.

If you exercise a call option based on the S&P 500, you don’t have to buy all 500 stocks in the index. That would be ridiculous. The index value is just a gauge to determine how much the option is worth at any given time.

Difference 3: Settlement Style

As of this writing, all stock options have American-style exercise, meaning they can be exercised at any point before expiration. Most index options, on the other hand, have European-style exercise. So they can’t be exercised until expiration.

But that doesn’t mean that if you buy an index option, you’re stuck with it until expiration. As with any other option, you can buy or sell to close your position at any time throughout the life of the contract.

Difference 4: Settlement Date

The last day to trade stock options is the third Friday of the month, and settlement is determined on Saturday. The last day to trade index options is usually the Thursday before the third Friday of the month, followed by determination of the settlement value on Friday. The settlement value is then compared to the strike price of the option to see how much, if any, cash will change hands between the option buyer and seller.

Difference 5: Trading Hours

Stock options and narrow-based index options stop trading at 4:00 ET, whereas broad-based indexes stop trading at 4:15 ET. If a piece of news came out immediately after the stock market close, it might have a significant impact on the value of stock options and narrow-based index options. However, since there are so many different sectors in broad-based indexes, this is not so much of a concern.

Now for the disclaimer

All of these are very general characteristics of indexes. In practice, there are lots of small exceptions to these general rules. For example, the OEX (that’s the ticker symbol for the S&P 100) is one big exception. Although the OEX is an index, options traded on it have American-style exercise.

This table highlights a few of the general differences between index options and stock options. But make sure you do your homework before trading any index option so you know the type of settlement and the settlement date.

Options Guy’s Tips

As you read through the plays, you probably noticed that I mentioned indexes are popular for neutral-based trades like condors. That’s because historically, indexes have not been as volatile as many individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

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Weekly Options Trading Explained

For First Time Investors and Seasoned Veterans

Whether you have a small investment account or a large account, you should consider investing in options.

With options, it doesn’t matter whether the market is moving up, down or sideways—you can still improve on your investment.

Because options operate through leverage, you don’t need to start with a large sum of money.

Options do move faster than the underlying stock that it is tied to, so it is important to learn from someone who knows what they’re doing—someone like Chuck Hughes.

Chuck Hughes has been investing in options for almost three decades. Although he began with a small sum of money, he was able to gain almost $500,000 in profits through options investing —in his first two years.

Chuck Hughes Interview

Listen to Chuck Hughes, a veteran stock, options, and futures trader and an 10 time winner of the Investing Trading Championship. Chuck will discuss in detail the indicators he uses to select trades accurately and cover his new Weekly Options Program.

Option Investing – A Weekly Option Trading Strategy

Even in these hard financial times, it’s important to keep a positive outlook on investing and trading—especially when it comes to option investing.

Despite the difficult times that people trading in the stock market have found lately, Chuck Hughes’ option investing has produced over $3.3 million in actual profits in the past five years.

Now is not the time to shy away from trading and investing—now is the time to act smarter about it.

That’s why Chuck Hughes started the Weekly Option Trading strategy—to help small investors trade smarter than ever.

The Weekly Option Trading strategy is an exclusive recommendation service that Chuck Hughes himself moderates and posts on a weekly basis. The trading strategy includes recommended trading signals in option investing, and its viewership is limited to the members of the trading strategy.

Weekly Option Trading strategy Profits

Closed Options Trades

View Chuck Hughes’ weekly options trading profits from all of this most recent closed trades.

,

Weekly Option Trading strategy

Closed Trade Profit Results

As of ​​April 1, 2020

Month Profit/Loss Return %
March 2020 $ 12,207.60 5.3%
February 2020 $ 4,685.00 1.2%
January 2020 $ 32,490.00 209.3%
December 2020 $ 29,894.00 59.3%
November 2020 $ 14,779.00 37.7%
October 2020 $ 23,592.00 66.7%
September 2020 $ 28,100.80 37.8%
August 2020 $ 33,579.00 997%
July 2020 $ 33,055.00 76.6%
June 2020 $ 21,014.00 78.9%
May 2020 $ 18,781.00 24.8%
April 2020 $ 5,533.00 10.2%
March 2020 $ 29,282.00 90.2%
February 2020 $ 20,250.00 141.6%
January 2020 $ 15,529.00 34.8%
December 2020 $ 99,834.00 81.1%
November 2020 $ 16,832.00 21.1%
October 2020 $ 10,399.00 7.6%
September 2020 $ 26,697.00 245.9%
August 2020 $ 12,280.00 49.6%
July 2020 $ 24,112.00 90.4%
June 2020 $ 17,296.00 37.5%
May 2020 $ 19,338.00 17.0%
April 2020 $ 7,684.00 12.3%
March 2020 $ 12,275.40 2.5%
February 2020 $ 25,590.00 42.9%
January 2020 $ 37,320.00 204.2%
December 2020 $ 20,256.00 669.8%
November 2020 $ 34,750.00 168.7%
October 2020 $ 180.00 15.5%
September 2020 $ 28,032.00 88.5%
August 2020 $ 18,891.00 65.6%
July 2020 $ 25,088.00 1,298.6%
June 2020 $ 11,950.00 43.2%
May 2020 $ 15,729.00 278.5%
April 2020 $ 15,104.00 58.5%
March 2020 $ 8,100.90 18.8%
February 2020 $ 11,778.00 68.6%
January 2020 $ 11,100.00 83.6%
December 2020 $ 10,466.00 56.1%
November 2020 $ 5,345.00 15.3%
October 2020 $ 10,951.00 10.3%
September 2020 $ 11,328.00 418.9%
August 2020 $ 20,466.00 41.5%
Ju ly 2020 $ 11,464.00 310.2%
June 2020 $ 12,254.00 36.7%
May 2020 $ 11,206.00 35.2%
April 2020 $ 11,058.00 19.8%
March 2020 $ 13,486.00 83.9%
February 2020 $ 7,441.40 14.5%
January 2020 $ 14,673.00 9.2%
December 2020 $ 32,063.00 77.6%
October 2020 $ 3,566.00 165.2%
September 2020 $ 25,566.00 27.8%
August 2020 $ 48,846.00 33.3%
July 2020 $ 13,520.00 66.80%
June 2020 $ 14,835.00 107.3%
May 2020 $ 11,952.00 126.2%
April 2020 $ 14,188.60 30.9%
March 2020 $ 12,212.00 60.1%
February 2020 $ 12,900.00 109.4%
January 2020 $ 14,754.00 87.5%
December 2020 $ 13,762.00 345.0%
November 2020 $ 17,544.90 1,059.4%
October 2020 $ 14,158.00 23.5%
September 2020 $ 16,426.00 165.2%
TOTAL PROFIT $1,2​52,912.75

Open Options Trades

View Chuck Hughes’ weekly options trading profits from all of this most recent open trades.

Weekly Option Trading strategy

Open Trade Profit Results
As of ​​​​​April 1, 2020

Portfolio Profit/Loss Return %
Option Portfolio $ -754.00 -2.0%
Small Account Option Portfolio ​$ 1050.00 10.4%
Covered Call Portfolio $ 107,221.00 138.8%
Small Acct Covered Call Portfolio $ 70,892.00 146.8%
Market Neutral Portfolio $ 60,677.00 63.3%
Option Spreads $ 27,597.00 55.0%
Super Stock Portfolio $ 65,817.00 222.3%
Total Profit $ 332,​500.70

If you’re getting started in options investing, then you should consider hiring an options trading strategy—and the easiest way to do that is through the Chuck Hughes Weekly Option Trading strategy. Join the team, and start watching your option investing dollars multiply!

Sign up for Chuck’s Weekly Options Trading Strategy today by clicking below, or learn more about option trading strategies. You can also learn more by watching some of our weekly options trading strategy videos here.
Sign Up

What is Weekly Options Strategy?

Weekly Options Strategies provide a short-term trading solution. They expire every week on Friday at the market close for stocks and ETFs. Technically they have six market trading days. There is one week of every month when these options are not available.

Let’s talk about the reward advantages. Weekly options give you an opportunity to pay for what you need, which require less capital in the long run. You will also sell each week instead of once a month. You’ll significantly reduce the cost for trades when considering longer-term spread trades and can hedge portfolios against event risk. Trading weekly options allow investors to start small. With this system, a little investment can yield great reward. One thing to remember – weekly options will expire quickly, and your trade will have less time to recover.

Using Weekly Options Strategies

There are a number of strategies that can be advantageous to stock traders. Knowing which ones and their terms can be beneficial and will guide you in setting up a stock trade is key. Here are a few: Buying a Call; Buying a Put; Selling a Call; Selling a Put; Buying a Put (Debit) or Call Spread; Selling a Call or Put (Credit) Spread; Buying a Butterfly Spread; Double Calendar Spread; Call or Put Calendar Spread; Call or Put Diagonal Spread.

Why Options Trading?

Before you begin, determine why you want to delve into weekly options trading. If you don’t have any experience in this area, this is one of the easiest ways to start. Once you master trading weekly options, you’ll have a strategy that will keep generating income. This system doesn’t rely on whether or not the stock market fails or succeeds. That means your risk is limited, but your options are endless. With this technique, you’ll be able to diversify your investments while maintaining control.

Chuck Hughes Weekly Options Strategies

Explore the different ways you can trade weekly options that garner great results! Here are some of the topics covered:

    ETF Price Trend
    Chuck uses a simple Trend indicator to identify ETFs for weekly covered call trading. His weekly covered call strategy utilizes a three-step process for selecting ETFs that have the best potential for profit. For only 20 minutes a week, this process will help incur less risk than a buy and hold strategy.

Weekly Paycheck Strategy
This will generate a weekly income from selling call options on ETFs. There are three criteria used to select ETFs for cash payouts.

  • Retired and Collecting a Weekly Paycheck
    Generate cash income by selling weekly call options against existing stock/ETF positions.
  • Chuck takes you through his EMA System and Investing with the Trend tactics to ensure you have all the tools you need to succeed. How does Chuck do it? His trend trading system relies on historical trends and reliable financial data to help investors make informed decisions. While most investors study the negative aspects of the trend, Chuck focuses on positive growth among companies. It’s important to have a trend trading system in place that will assist with selecting stocks that are poised to make a profit, calculate risk reduction, and insight for informed buy and sell decisions.

    How can Chuck Hughes help you?

    As someone who’s been in the business of trading and generating a profit for many years, you’ll learn from the best. With over 30 years of experience and a stellar options trading record, you won’t find another trading strategy that has both the insight and a proven system that works. A ten-time champion options trader, you’ll learn how to trade with the best!

    In the trading game, a strategy is key to seeing rewards. Although there is always some level of risk, having a strategic mindset and system in place that will help take you to the next level makes the difference. Chuck helps you calculate risk to achieve maximum rewards when you trade. Knowing the tips and tricks as a new trader will give you the advantage.

    Come be a part of a winning system. The Chuck Hughes Options Trading Strategy is tailor-made to help you learn the tools you won’t find anywhere else on the market. From an income trading strategy to options spreads and Chuck’s own personal tips like prime trade select, you’ll gain more than you ever anticipated.

    Don’t let your first venture into trading be one that is unsure. Having the advice and expertise of a trading whiz who understands the system and how to make it work to your advantage can give you the confidence you need. If you’re ready to start trading and seeing rewards call the team at Chuck Hughes today. Dial 866-661-5664 or contact us online. Speak to someone about these trading strategies that can change your life! Tap into Chuck’s knowledge and make the right decision now!

    Weekly Options Trading Webinar Video

    ​In this webinar Chuck will discuss his strategies for trading weekly options. This program defines parameters of finding stocks and options with the best profit potential. Chuck will show an analysis of:

    • Defining a trade
    • Selecting an stock or option
    • Executing a strategy with the best profit potential

    Generating Weekly Cash Income from Options

    When purchasing a call option, the underlying stock/ETF must increase in price or the call option will lose value possibly resulting in a 100% loss for your call option trade.

    This video will explore the option spread advantages listed below:

    1. Increased Profit Potential – A call option spread is created by purchasing a call option and selling a call option with a higher strike price. If you have an existing profit for a call option purchase and leg into an option spread, the spread can typically increase the existing profit potential of an option purchase by 50% to 100% or more.

    2. The Option Sale Provides Downside Protection – The sale of a call option results in cash being credited to your brokerage account. This reduces the cost basis of the option purchase and provides downside protection in the event the price of the underlying stock declines in price.

    3. Reduces Risk – The sale of a call option results in cash being credited to your brokerage account which can typically reduce the risk of a call option purchase by 30% to 50% or more.

    4. Allows You to Maintain Positions During Volatile Markets – The downside protection provided by the sale of a call option to create a spread can help you maintain your spread trade during volatile markets. If you traded option purchases only, volatile price swings in the underlying stock can result in getting stopped out of your directional call option trade.

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    5. Spreads Can Be Profitable If a Stock Goes Up or Down – Depending on the strike price, option spreads can be profitable if the underlying stock price increases, decreases or remains flat at option expiration

    Index Option Trading Explained

    Read Part 1 of our information to learn more about what you need to know before trading index options. You’ll learn about the benefits of listed index options, diversification, pre-determined buyer risks, leverage, and guaranteed contract performance. When you’re ready, complete the Firstrade online application.

    Benefits of Listed Index Options

    Like equity options, index options offer the investor an opportunity to either capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace.

    Diversification

    Index options enable investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. To obtain the same level of investment diversification using individual stock issues or individual equity option classes, numerous decisions and transactions would be required. Employing index options can defray both the costs and complexities of doing so.

    Predetermined Risk for Buyer

    Unlike other investments, where the risks may have no limit, index options offer a known risk to buyers. An index option buyer absolutely cannot lose more than the price of the option, the premium.

    Leverage

    Index options can provide leverage. This means an index option buyer can pay a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from relatively small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer’s risk is limited to the premium paid. However, because of this leverage, a small adverse move in the market can result in a substantial or complete loss of the buyer’s premium. Writers of index options can bear substantially greater, if not unlimited, risks.

    Guaranteed Contract Performance

    An option holder is able to look to the system created by OCC’s Rules and By-Laws (which includes the brokers and clearing members involved in a particular option transaction) and to certain funds held by OCC rather than to any particular option writer for performance. Prior to the existence of option exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one’s position prior to the expiration of the contract.

    As the common clearing entity for all U.S. exchange-traded securities option transactions, OCC resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer. As a result, the seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver cash equal to the exercise amount of the option to OCC. This will in no way affect the right of the original buyer to sell, hold, or exercise his option. All premium and settlement payments are made to and paid by OCC.

    We hope you have found the first part of our guide to how to trade options helpful. Continue with Part 2 here. Start trading options at Firstrade today!

    © 2020 The Options Industry Council. All Rights Reserved. Visit us online at www.optionseducation.org

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    Options Trading Probabilities Explained – POP vs ITM vs OTM vs P50 vs Touch…

    When it comes to options trading, there are many different measures of probabilities. Most of them sound very similar: probability of ITM, probability of OTM, probability of touch… but actually all of them represent something different. It is important to be aware of all the differences so you can take advantage of all these indicators. In this article, I will present and explain all these different probabilities that an option trader needs to be aware of.

    What is the Probability of ITM

    ITM stands for In-The-Money, so the probability of ITM is the probability that an option will expire In-The-Money.

    Put options are ITM when the underlying’s price is below the strike price and call options are ITM when the underlying’s price is above the strike price. If you didn’t know this yet, I recommend checking out my lesson on options trading basics .

    The probability of ITM can give you an idea of what the market expects from an asset. Furthermore, the probability of ITM should influence your option strike selection. If you want to trade conservatively with a high probability, you should find a strike price(s) that give you a high probability of profit.

    A good alternative to the probability of ITM is the option Greek Delta. These two usually are almost the same (Delta normally is slightly greater). On the right-hand side, you can see a table in which the probability of ITM and Delta are compared for different options. As you can see, Delta is always slightly greater. Nevertheless, it can be used as an alternative for the probability of ITM.

    If you buy a call option that has a 60% probability of expiring ITM, you might think that this is your probability of profiting on that long call position. However, as you have to pay a debit for that call option, your breakeven point is moved against you. Therefore, the probability of closing that long call position for a profit is actually lower than the probability of ITM.

    The probability of ITM is not the same as the probability of profit.

    What is the Probability of OTM

    The probability of OTM is more or less exactly the opposite of the probability of ITM. The probability of OTM shows the probability that an option will expire Out of The Money (or worthless).

    The probability of OTM can be calculated by subtracting the probability of ITM from 100:

    100 – Probability of ITM = Probability of OTM

    This can also be used to get an idea of what the market expects from an asset’s price. Furthermore, this is the probability to look at when selling options. When selling options, you want the sold options to lose some or ideally all of their value and the probability of OTM shows the probability of exactly this happening.

    In other words, when selling options, you should ideally find options that don’t have a too low probability of expiring worthless/OTM.

    Note that the probability of OTM does not show your probability of profiting on an option trade. When selling options, you collect a credit which will move out your breakeven points and thereby, increase your probability of profiting. This is not included in the probability of OTM.

    The probability of OTM simply shows the probability of the underlying’s price being below the strike price for call options and above the strike price for put options.

    What is the Probability of Touch

    The probability of touch shows the probability that the price of the underlying will touch (or breach) the strike price.

    Usually, the probability of breach is about 2x the probability of ITM. Here is a brief example:

    XYZ is trading at $100 and you decide to buy the 110 call option that has a 30% probability of ITM. The probability of touch for this option will be around 60%. This means that the theoretical probability that XYZ’s price will rise to $110 sometime before expiration is around 60%.

    While the probability of ITM and OTM focus on the expiration date, the probability of touch focuses on the time before that.

    From the fact that the probability of touch is about 2x the probability of ITM, you can learn a lot. Just because you sell an option with a high probability of OTM, does not mean that it won’t go against you and show a paper loss sometime before expiration.

    Here is yet another example to clarify this:

    ABC is trading at $45 and you sell the OTM put option with a strike price of 38. The probability of OTM for this option is 70%, which is fairly high. In other words, there is a 70% probability that ABC’s price will be above $38 on the expiration date.

    The probability of ITM for the 38 put option is 30% (100 – 70 = 30). Therefore, the probability of touch is about 60% (2 x 30). A probability of touch of 60% means that there is about a 60% chance that ABC’s price will drop down to $38 before the expiration date.

    So actually, the probability of that happening is greater than the probability of it not happening. Your short put position will show a paper loss when this happens.

    If you now have the trading approach to cut losses quickly, you probably would close your position for a loss. This isn’t necessarily the smartest thing to do though. If looked at the probability of touch when entering your position, you would have seen this price drop coming (with a 60% probability). Thus, you probably would have held on to your position.

    In cases like this, it isn’t unlikely to see the trade turn around again. My point is that due to the probability of touch being 2x the probability of ITM, it is likely to see trades go against you (when selling).

    Many option trades show a paper profit sometime before expiration. However, if you manage to hold on to them, they often turn around. Therefore, the trading approach ‘cut your losses quickly and let your winners run’, is not applicable to options selling.

    Nevertheless, you shouldn’t hold on to losers forever, especially if you are trading undefined risk strategies . Always define your risk before opening a trade and then stick to this max risk level. Just make sure to give the underlying’s price some room to move, so that your losing trades still can turn around and become winners.

    What is the Probability of Profit (POP)

    The probability of profit factors in the premium received/paid which moves the breakeven point of a trade. So the probability of profit shows the theoretical probability that a trade will be profitable at expiration.

    A common misconception is that the POP is the probability of reaching max profit. This is not true. The POP simply shows the probability of making at least a penny on a trade.

    Let’s go over another example:

    You sell a call (credit) spread on XYZ (XYZ is currently trading for $265). The short strike of the call spread is 270 and you collect $1 for the entire spread. This means that your breakeven point is at $271. Let’s say the probability of profit is 65%.

    This means that the probability that XYZ’s price will expire at least one penny below $271 is about 65%. If XYZ’s price is at $270.99, the call spread won’t reach max profit.

    call spread payoff diagram

    What is P50

    P50 is another very useful probability. It shows the probability that your trade will reach 50% of max profit (for defined risk trades). I have only seen this probability displayed on the broker platform tastyworks. Most other brokers probably don’t have this feature.

    A wide variety of different backtests from tastytrade have shown that taking profits at 50% of max profit is ideal for most short option strategies. That is also why they show you the probability of reaching 50% of max profit.

    The probability of reaching 50% of max profit usually is higher than the POP. This is the case because 50% of max profit normally is reached before the expiration date and therefore, the trade can be closed earlier.

    This is how tastytrade describes their P50 calculation:

    “The p50 feature takes the trade you’ve loaded onto the trade page and runs it through a monte carlo style simulation, and calculates the theoretical probability that your position reaches 50% profit over 10,000 occurrences.”

    How to use the different probabilities

    Now you know what the different probabilities mean. However, you don’t necessarily know how to use the probabilities for your trading. That’s what we will get into now.

    The probabilities of ITM/OTM can be used to give you an idea of what price movement the market expects from an asset. Furthermore, you can use these probabilities for the strike selection. For instance, when you are setting up a credit spread, you can look at the probability of OTM to find a fitting short strike.

    The probability of profit gives you an idea of the likelihood of winning on a trade. POP takes another important factor, namely premium into account and therefore, you should rather look at POP than at the probability of ITM/OTM.

    Just because an option has a high probability of expiring ITM, does not mean that it is a good buy. If you factor in the premium that you have to pay to open the long position, the probability of actually making money is much smaller than the probability of that option expiring ITM.

    So the probability of profit is one of the most important aspects to look at before sending an opening order for a trade.

    The probability of reaching 50% of max profit (P50) can also give you great insights into a trade, especially if you are planning on taking profits at 50%. However, if you put on a trade because it has a high p50 number, you should not try to go for max profit. P50 is especially useful for option premium sellers. Generally, it is a very good idea to take profit at 50% of max profit on most short option strategies like credit spreads, short iron condors, short strangles etc.

    The probability of touch figure should also influence your trading. If a strategy has a high POP and a high probability of touch, you shouldn’t cut losses as soon as the trade goes slightly against you. Remember that most option trades are tested and show paper losses before expiration. That is also the reason why the probability of touch is 2x the probability of ITM.

    Just because the underlying’s price moves against you, does not mean that it can’t turn back around. Just make sure to define your risk before putting on a trade so that you protect yourself.

    Call Spread Example

    Here is a brief example of all the probabilities on a call credit spread:

    The underlying asset is QQQ and was trading at $171.5 at the time of making this example trade.

    As you can see on the image above, the probabilities are:

    • POP: 64%
    • P50: 73%
    • Probability of ITM: 42%
    • (Probability of OTM: 58%)
    • Probability of Touch: 84%

    The max profit of the call spread is $214 and the max loss is $286. If you are familiar with call spreads, you should know that the max profit is equal to the total credit collected. Thus, the breakeven point can be calculated by adding the premium collected to the short strike price (which is 174). So the breakeven point for this call spread is $176.14 (174 + 2.14).

    Just like I presented earlier, the POP is greater than the probability of ITM because the premium collected moves out the breakeven point. So even though the probability of the short option expiring ITM is 42%, the overall probability of having a profit on the expiration date is 64%. Note that this does not mean that this trade has a 64% probability of reaching $214 max profit. There is a theoretical probability of 64% that QQQ’s price will expire at least one penny below $176.14, the breakeven point.

    The probability of reaching 50% of max profit ($108) is about 73% which is even greater than the POP.

    Last but not least, the probability that QQQ’s price will test the short strike sometime before the expiration date is 84% which is 2x the probability of ITM (2 x 42 = 84). In other words, it is quite likely that the call spread will be tested and show a paper loss sometime before expiration.

    Here is an infographic that displays the probabilities of the call credit spread visually:

    (If you want to use this infographic, go ahead. Just make sure to link back to this article.)

    Hopefully, this example helps you with the understanding of the different probabilities.

    Conclusion

    Even though probabilities are important in options trading, they aren’t everything! It is important that you don’t only look at the probabilities of an option trade.

    Just because a trade has a high probability of profiting, does not mean that it is a good trade. Make sure to always look at other essential factors like max profit, max loss, risk to reward ratio, implied volatility, days to expiration… as well.

    For instance, a trade with a 90% probability of profit might sound good. However, if that trade only has a max profit of $5 and its max loss is $1000, the trade is bad!

    Normally the following is the case: the higher the probability of profit, the lower the max profit and the greater the max loss.

    So make sure to look at the probabilities AND other important factors!

    Hopefully, you found this article helpful and learned how the presented probabilities can improve your trading performance. Sadly, not all brokers show these probabilities. On the following image, you can see that all of the probabilities can be displayed on a single page within tastyworks:

    That is why I use tastyworks, the only broker I know that shows all of the above probabilities.

    If you want to learn more about tastyworks, make sure to read my tastyworks review !

    14 Replies to “Options Trading Probabilities Explained – POP vs ITM vs OTM vs P50 vs Touch…”

    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?

    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.

    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!

    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.

    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.

    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.

    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

    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.

    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?

    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.

    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?

    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.

    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?

    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.

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