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Do you know how Option Probability works?


We now know that Options trading is the best and most profitable way to profit in the financial world. Whether you are an option buyer or a seller, whether you can predict the market certainty or not, whether there is a high or low volatility market, options have your back. The price of every instrument, like a commodity, currency, stock, etc., keeps changing, giving birth to various successful options strategies. No matter what the situation is from above, options trading has a strategy for all such situations.


Let us today understand the concept of Option probability and learn how it works and what factors you need to see while checking for the probability of the options.


Options profitability:

When will a call option holder (here, the buyer of the stock) be able to make money? The answer is when the stock price exceeds the strike price mentioned in the contract on the day of the contract expiry or within that duration, the call option contract holder makes money. Similarly, when does the put option contract holder make money? The put option holder makes money when the price of an asset drops below the strike price before the expiry of the contract. The profit is the amount of the variation between the stock price and strike price during the time of the options expiry as it reaches expiry.


Another way to earn a profit is when the option seller's strike price, even after appraisal, stays below the strike price throughout the duration of the contract; then option seller might get a small profit. While on the other side, for the put options contract, the profit is when the stock price of the underlying asset stays above the strike price. In both cases, the earnings of the contract holder are limited to the amount they received by selling the call and put contracts as premium.

The difference between option buying and selling:

One interesting thing which I love about the options market is the loss. Suppose the buyer predicts the profit potential of any stock; then he may generate unexpected returns on his position, as there can be an infinite difference between the strike price and stock price. In this case, your maximum loss will be limited to only up to the premium you paid to enter the contract, and the profit potential is technically very high.


What about the profit of the option seller? This was about buying the call option. An option seller has a relatively low chance of making money than the option buyer. The reason is his earnings are limited to the amount he charged as a premium for selling that contract. Here, the potential loss is technically unlimited, while the profit is limited and known beforehand.


Now comes the main question, why do I need to sell the options contract or write an option contract? The reason behind this is psychological; it is believed that the options seller gets the upper hand in the market. During major times the contracts expire worthless at expiry. The option seller's probability of winning the trade is much higher; thus, traders tend to write off the contracts.


The risk-appetite of the traders:

If you are given two choices, one is to invest low and wait for the market to make a big move and turn itself in your favor for you to make a considerable profit. Or, instead, you will like a small investment and small profit with smaller and safe bets, where the chances of losing money will be limited?


The new traders should opt for long positions strategies because the exit with the short strategies requires much experience, and if they do not get adequately executed, you may fall into a significant financial loss.


You must understand that every trader has different trading goals and varying risk-bearing capacities. You can handle and speculate every position in your favor if given proper training.


What are the benefits and associated risks of the options strategy:

There are generally two types of options contracts: call and put options. When we combine them in different formats, we can develop more advanced and profitable options strategies. Many such strategies are available in the market for each type of market condition. But, on this page, we shall only focus on the four most basic strategies in options trading. They are as follows:

  • Buying a call option

  • Selling a call option

  • Buying a Put option

  • Selling a Put option

Buying a call option:

This options strategy is the widely used strategy in the market. In this strategy, the investor can lose only the amount paid as the premium to enter into the contract while the potential to profit is much higher. But again, this option strategy does not have enough chances to make a profit.


In this strategy, if the price of the underlying assets closes above the strike price at expiry, the trader will immediately exercise the contract, buy the options at the lower price and sell them to the current (higher) price and benefit from the price difference. Here, you must remember that the difference between both prices should be good enough to offset the premium paid.


If the market is not appreciating, the stock price moves below the strike price. Here the trader is not obligated to execute that contract but will lose the premium paid.


Buying a Put option:

It is just like buying a call contract in a bearish market. These options contracts are majorly found in the commodities market where there is a need to protect the produce from the market crash situation. Buying a put option is considered safer than short selling. The strategy is most commonly used for hedging and reducing risk.


Selling a call:

Selling a call option is again one of the best options strategies. Few experts often write off the call options assets against which are already there in their portfolio. Their intention in doing this is to earn extra income in the form of a premium from those assets which are not profitable in the portfolio. If the price appreciates, it will help traders cover their position. When this type of strategy is used, it is called the Synthetic short put in the financial world.


Although the short positions can be profitable in the long run but are considered risky, novice traders are advised not to short-sell because it demands a lot of expertise and accurate calculations.


Selling a Put:

As said before, selling an options contract needs a lot of calculations and expertise as there are chances of getting a high profit only if they are correctly executed. If the put contract holder exercises his right to sell the contract and convinces the buyer to buy at the market price, he can make money. On the other hand, if the seller keeps the asset in the hope of price appreciation, it will create more speculation and increase the chances of losing. This is the exact opposite of holding put options. The main goal of the options seller here is to calculate the benefits he can accumulate via premium.


Knowing Options spreads:

Options are never used individually; they are always combined with one another in a professional way to make the trade more profitable. When these options are combined, they are called spreads. The spreads add more profit and reduce the amount of premium payment. To maximize profit, you can make almost any combination in the bearish and bullish market. A prepare risk management strategy on hand will be an added advantage.


How to select the right options according to the market?

In this section, you will find some tips which will be very helpful for you to select the right options.

When you want to take advantage of price rise or decline, you may use a single options contract, but using the spreads or the combination of the contracts will be a wise choice. You can make bull spreads and bearish spreads according to the market.


Suppose the market seems bullish; in this scenario, you may buy a call option with a low strike price and sell another with a higher strike price, thereby earning on the premium by restricting the further benefits.


In the same way, if the market seems bearish, the bear put strategy is used. The bear put spread is created by purchasing put options at a higher price and selling others with a lower strike price.

In this way, according to market circumstances, traders can make different strategies.


Understanding the concept of Volatility:

In the stock market, you often encounter two types of Volatility out of many. These are historical Volatility and Implied Volatility. The historical Volatility will help traders to measure the price changes in the underlying asset over its lifetime. On the other hand, the implied Volatility will reveal how the asset will perform in the future. This information will help the traders to gauge the Volatility in the market. There are many such strategies in which Volatility plays a vital role, meaning the higher the Volatility, the higher the profits.


Expiration

You must remember that as the contract comes closer to the expiry, it faces high Volatility in the market. The more time the contract has to expire, the more chances the stock price has to reach or exceed the strike price. Investors who can create a proper balance between the associated risk and potential rewards can stay in the market for a long.


Lastly, do your research and homework, and make use of software's available for free in the market. Listen to what the market has to offer you. Please do not rely on anyone's advice; they may not always be right. Especially those who are into the trading market will come and try to advise you on what you should do and what not.

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