Daily Stock Market Equity and Options Trading Commentary

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Tuesday, June 9, 2009

Calculating Option Probability

I have had a lot of questions about how I get option probabilities, so I decided to create this post. There are several ways that option probability is calculated, and all yield different results. The probabilities I use in most of my blog posts and articles are from the Greek Delta value. Delta gives the amount the option price (premium) will change in value with each additional $1 move in the underlying stock, it also gives a value known as the risk neutral probability. Delta changes on a constant basis, as the input values change to calculate it (underlying stock price, days left until expiration, volatility, interest rate, etc...). Delta also varies among the different brokerages as they may use different input values to calculate it. The reason I use Delta (risk neutral probability) is because it is very easy to obtain (when I am giving 10 or more option ideas, it saves me a lot of time) and gives me a general idea of what the CURRENT options market is factoring in for that strike price. The Delta (risk neutral probability) will almost never be the same value two days in a row (I have never noticed it being the same in my experience with trading options). Too much emphasis should never be placed on option probability, as there are just too many variables that affect it on a day to day basis.

For a quick example check out the Delta value on an option that is very deep in the money and close to expiration, the delta should be very high (maximum 1). Let's say Delta is .97 for strike price X which means with each $1 change in the underlying stock the option price (premium) for strike X changes by $0.97 (97 cents), and the current options market is factoring in a 97% chance the stock closes at or above strike price X at expiration.

As stated before too much emphasis should never be placed on Delta (risk neutral probability), or any other variable for that matter.

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