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What is options trading? Probability of touch vs. probability of loss

5-Year Results
5-Year Results

In our quest to understand trading options for income, the topic of this article covers two important metrics: the Probability of Touch, and the Probability of Loss.

The POT (probability of touch) is defined as the price of the underlying asset being ITM (in the money) or breaching the short Strike of the option (whether a Call or Put) prior to expiration, but at expiration the price of the underlying is OTM (out of the money) so the short Strike expires worthless. For example, if we have a Call credit spread for stock XYZ with the following short Strike at 100, then if the price of XYZ goes to $120 (ITM since it has exceeded 100) a breach has occurred and the option's short Strike has been touched. If at expiration the price of XYZ is at $95, then the price is OTM and the option expires worthless; this is counted as a touch, but not a loss.

The POL (probability of loss) occurs when at expiration, the position loses at least 1 cent or more; it does not necessarily mean maximum loss. POL is the contra of POP (probability of profit), an important and often applied metric. For example, if the POP is 90%, then POL is 10% (or 100% - 90%). Given the example above for POT, if at expiration the underlying price is $101 then the position will have a loss; this is counted as a loss (and also as a touch).

Mathematically, the POT is very close to twice the POL. If POL is 5%, then we would expect the POT to be 10%.

Options Annex performed extensive testing on the SPX (S&P 500 index), from May 2008 through May 2013 representing 269 weekly trades (not counting adjustments). We wanted to see how the POT and POL compared with actual touches and losses during that period, and during the full years of 2009, 2010, 2011, and 2012. We looked at both Call and Put credit spreads, $25 wide (risking $2,500 per trade). We compared actual with expected (Act / Exp for Call and Put credits spreads separately) for three levels of risk using expected move: 1 SD (standard deviation), 1.5 SD, and 2 SD; or POPs of 84%, 95%, and 97.5% respectively.

The results were quite interesting (see charts above) for the 5-year period (IV of 25.54%; 269 total trades)...

First, the actual touches and losses were far below either POT and POL at all risk levels for both the Call and Put credit spreads. This makes the SPX an excellent choice for trading options.

Second, the Call credit spread had lower actual touches and losses percentages than the Put credit spread, except the 2 SD losers which were both zero.

Third, the Call credit spread at 1.5 SD had nearly the same percentage of touches as losers. This could indicate that if the Call credit spread is touched, it is more likely to become a loser.

And fourth, for the Put credit spread at each risk level, the difference in percentage between actual touches and losses is greater than the Call credit spread. This is especially true at 1.5 SD, with a touch vs. loss ratio greater than 16-1. This means that if you place a Put credit spread at 1.5 SD and it is touched, you are more likely to have a profitable trade by expiration; that is, it will expire OTM.

When looking at each year separately, we find the following...

First, the only time the actual touch exceeded POT was in 2011 (13.46% vs. 10%) at 1.5 SD.

And second, there is a correlation between IV (implied volatility) and the Put credit spread. The highest IV in 2009 (31.39%) resulted in no losses at all risk levels, and better actual percentages than the Call credit spread at all risk levels for both actual touches and losses (except at the 2 SD in which both were zero).

In conclusion, higher IV does help the Put credit spread to surpass the Call credit spread percentages. And, the average 5-year figures for the SPX Weekly indicates far lower actual percentages for both touches and losses at all levels of risk.

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