# How to use Probability Calculators with Options Trades

**Introduction**

One of the most common mistakes novice options traders make is to only take into account

the risk/reward ratio of an options trade without considering the probabilities involved in the

specific trade.

It is not uncommon to hear such a trader comment on the fact that the trade has ‘unlimited

profit’ potential while the maximum loss is limited to the amount paid for the option. This is in

fact a common catchphrase used by some brokers to recruit new options buyers.

If the prospective options buyer knew that there was in some cases only a 5% or 10% chance

the trade would turn profitable, such a trader might have made a different decision. This is

why it is so important to learn how to use a probability calculator early in your options trading

career.

**Probability calculator**

Fig. 8.22 show what a typical probability calculator looks like. There is more than one

website where traders can get free versions of this type of software, called Monte Carlo

Probability Calculators.

Fig. 8.22

What this does is, given the price and the volatility of the underlying asset and the expiration

date and strike price(s) of the option(s), calculate the probability of certain events taking

place, e.g. that the asset price will expire above or below the strike price.

In this example one would therefore enter the current price of the underling under Asset

Price. The Upside Price and Downside Price = the strike prices of the call or put options

involved. A trader who simply wants to buy a call option should enter the strike price in the

Upside Price field and simply enter ‘1’ in the Downside Price field.

Then enter the Expiration Date of the option in the appropriate field. The Volatility is usually

provided by the broker and should go into the appropriate field. When one clicks on Calculate

the programme calculates the rest.

The result will look something like fig. 8.22(d) below.

Fig. 8.22(d)

The most important result here for the options buyer and seller is the percentage probability

that the price will close beyond the upside (call options) or the downside (put options). In this

example there is only a 5.11% probability that the option would expire In the Money; bad

news for the options buyer and good news for the options seller.

**A point to ponder**

There is more to this than it seems though. What is very important to remember, especially for

options sellers, is that the trade has to be managed. One can’t simply leave a Naked Put or a

Naked Call until it goes deep ITM.

It is therefore also important to look at the possibility that the price would ever exceed the

strike price (to the upside or downside) without necessarily expiring beyond that level. In Fig.

8.22(d) we see that the probability that the price would ever exceed the strike price to the

upside is 8.26%. While this is still relatively low, it is more than 50% higher than the likelihood

of the price actually expiring beyond this level.

The options seller might therefore have to buy back the option at a loss more often than

expected, because once the price of the underlying asset exceeds the strike price the option

is ITM and it could be exercised.