JJ Kinahan, Chief Market Strategist at TD Ameritrade, and guests break down the importance of understanding probabilities when building an option trading strategy.
This is Understanding Options. I'm your host, JJ Kinahan.
JJ: Hello, everyone, and welcome to the show. I'm JJ Kinahan, TD Ameritrade Chief Market Strategist. And today, I'm joined by two of my favorite guys, two of our education coaches, Pat Mullaly and Ben Watson. And the topic of the day today is probability. Welcome aboard, guys.
Ben: Hey, JJ.
Pat: How are you doing?
JJ: Great. Great to have you here. You know, guys, we talk about this all the time, that options are really nothing more than a giant set of probabilities, and we use them to weigh our risk versus our reward.
Pat: Yeah. And why that is important is because the real dilemma for a lot of investors is trying to understand the probabilities of something happening. So when we look at probabilities, when we look at options, that gives us the likelihood of that event happening within a certain time frame. And it gets expressed as a percentage.
Ben: Yeah, and if you remember, both call and put options have a probability of expiring either in the money or out of the money. And that's what helps us to determine what that probability really is, what we're looking at in terms of that probability number.
JJ: You know what? That's great points by both of you guys. And Ben, you just brought up in the money versus out of the money. So just a quick refresher for some of our listeners-- if a call option is in the money, its strike price is below the stock price. So conversely, for a put option, the strike price is greater than the stock price.
On the other end of that, an out-of-the-money call has a strike price that is above the stock price. And an out-of-the-money put has a strike price below the stock price. So you might want to listen to that one again in slow motion if I talk too quickly for you. But In the money, out of the money, very important concepts. And it relates to another term that people should probably be familiar with in options. And that, Pat, is going to be delta.
Pat: Yeah, so delta-- that's one of the first things that people learn about is delta. And what that option-- an option's delta does is it measures how sensitive the option's contract is to the changes in the stock price. In other words, an option's premium or price is going to increase or decrease by the amount of the delta. So basically, a delta of 50 means that the premium or price of the option will move up $0.50 for every dollar move that the stock moves up or down $0.50 by the dollar movement to the downside.
It also-- an interesting thing that people then learn about is that delta is also a proxy for probabilities. It's not perfect mathematically, but it's really close. So delta can go as high as 1. Or it can go as low as 0. So there's a big wide span of probabilities that can be understood and used in there for different purposes.
JJ: Absolutely, Pat. And relating everything you just said to where we started with in the money and out of the money, when you look at probabilities, the question we often ask is, what is the probability of an option expiring in the money. So looking at the delta, as Pat just said, will help you in a thumbnail way, say, on expiration day, here are the probabilities right now that the market is giving of that option of being in the money-- remember, higher delta options, higher probability of in the money, lower delta options, lower probability of being in the money.
And when I talk about buying versus selling on certain options, one of the things we like to look at is if we are going to buy, often we'll look at in-the-money options because they have a higher probability of being in the money. They have some intrinsic value. And selling options, we often look to out of the money, because there is no true intrinsic value. It is strictly time value. So it comes back to something we talk about a lot, and that's buying value and selling junk. And, Ben, I know you talk a lot about that also.
Ben: Absolutely. And you know, JJ, there's one more thing that we talk about an at the money, out of the money, in the money scenario, and that's that at-the-money position for an option where the strike price is equal to the stock price. And it's really kind of that even-money position. And there's a 50% probability of the option expiring in the money, and 50% probability of the option expiring out of the money. And it's really kind of that 50/50 probability scenario that we look at here.
Pat: That's where that 50 delta comes in.
Ben: Exactly. Yeah. So once you understand that difference between in-the-money and out-of-the-money options, you start to get that understanding of probability overall-- the probability of profit, the probability of touching-- those are all elements of this probability discussion that we have. And you can use those measures to estimate the likelihood of a trade success or failure even before you enter the trade, right, Pat?
Pat: Exactly, exactly. Very important to learn that and understand that can be a huge help to people down the road.
Ben: True. And you know, I just touched on intrinsic versus extrinsic value. And I think that relates really well to this. And if you guys want to jump in here, basically, if an option has intrinsic value, it's worth something. So what I mean by that is if the stock's trading $100, the 95 call has to be worth at least $5. It may be priced at $7, but 5 of that is going to be intrinsic value. I don't know if you guys want to add anything on extrinsic value also.
Pat: Well, so $2 of that $7-- if a premium is at $7, it has $2 worth of that time value. Now, that's going to erode over time. Something very important to understand is that time value is going to erode. So depending on the strategy that you choose, that becomes a very important part of the whole process.
Ben: Because you can either put that erosion of that time value in your favor or have it work against you, depending on the strategy you choose. And so that can help you to determine, hey, what strategy am I likely to pick in a particular situation and based on your assumptions of what the stock might do.
Pat: Right, right. Put those probabilities in your favor-- in the money, out of the money, at the money. Understand what they are. Understand that there's a high probability of something being touched. That's important. There's a high probability of something being out of the money. That's very important if you're buying something that's out of the money.
Ben: That's right.
JJ: All right, that's a great wrap-up for today, and that's going to conclude today's show. If you're listening, first of all, we appreciate it. Be sure to subscribe and tune into our next episode. You can find more option education at EssentialOptionStrategies.com. You can find me on Twitter at @TDAJJKinahan. Ben, what's your Twitter handle?
Ben: My handle is @BenWatson_TDA. And you can find me there on Twitter as well.
JJ: And Patrick?
Pat: I'm still working on my Twitter handle.
JJ: All right. Well, when they get the handle, @handsome that'll be Pat Mullaly. Thanks to you guys for joining me today-- great stuff-- and to you listening, really appreciate it. Thanks for taking time out of your day to join us. Good luck with your investing, and good trading, everybody. Thanks for tuning in.
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