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Option Basics - Probability of Touch

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At we always consider the risk associated with each trade using the Probability Model. As sellers of options that are far OTM (out of the money), we favor high probability of profit (POP) strategies with low failure rates or PITM (probability of expiring in the money). However, few option traders ever think about the possibility that the short strike of a high POP position (or trade) is breached or touched at any time prior to expiration; a statistic called POT (probability of touch).

So, how do PITM and POT differ? And how can POT help us improve our trades?

First, a key factor for both PITM and POT is implied volatility (IV). At a given short strike and DTE (days to expiration), as IV increases, so do the probabilities (PITM and POT).

Second, the difference between the two probabilities is as follows. PITM occurs at expiration; that is, the probability of the underlying being ITM at expiration (a losing trade). POT can occur at any time prior to expiration, and it is not necessary that it expire ITM; it could just as easily expire OTM (out of the money), and be a winning trade.

And third, as a general guideline, POT is typically twice PITM. For example, if PITM is 5% (remember, we are dealing with high POP trades of around 95%, so PITM would be 5%), then POT would be 10%. Understanding this means we can better weather positions that are touched with the expectation that 50% of the time they will expire OTM.

The importance of POT differs between American style options vs. European style options. The former can be exercised prior to expiration, while the latter only at expiration. Therefore, POT is a more useful statistic with American options than European options, since being ITM increases the risk of assignment (which occurs when the option is exercised).

Also with American options, it is more prudent to exit the position prior to expiration, usually with a profit target between 25% and 50% to avoid early assignment. Thus, POT gives us a more useful statistic to work with in determining our POP (100% - POT).

In conclusion, when considering the risk associated with a trade, POT is a useful statistic; especially with American options.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.



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