The Probability Of Touch In Options

Some trading platforms will give an investor the probability of a stock reaching a certain price at some point prior to the expiration of an option. This is known as the probability of touch. Let’s look at some examples.

Example Using Cash-Secured Put

On Nov. 25, 2020, at market close, Caterpillar (CAT) trades at $174.63. This trade will be what we use as our example. An investor may be willing to buy 100 shares of CAT if the price drops back down to $160 near the 50-day simple moving average.

In this trade, the investor sells one put option on CAT at the strike price of $160, with the expiration being in 23 days on Dec. 18. With the ThinkOrSwim platform configured to show the Delta and the Probability of Touch, we see that the $160 strike corresponds to the 14 delta.

The delta can be thought of as an estimate of how likely the option will be in-the-money at expiration. In this case, there is a 14% chance that the $160 put option will be in-the-money at expiration on Dec. 18. We also see that there is a 31% probability of touch. In other words, the price of CAT has a 31% chance of touching $160 at some point prior to expiration.

It makes intuitive sense that the probability of temporarily touching the price is greater than the probability of the price ending up below the price expiration. Roughly, it is about as twice as likely. Because 2 x 14% is 28%, which is close to 31%.

In a trade like this, whenever the price reaches the short strike, the investor is on the brink of a loss. That is why adjusting is such an important skill. Nevertheless, if the investor does find the strike price being tested, then about half the time, a loss does not occur (the price reverses in the investor’s favor) and the other half of time, the loss does in fact occur — assuming that the option is held to expiration.

Example Using Long Call

Suppose another investor is bullish on the overall market and decides to buy one call contract on the SPY with 50 days to expiration.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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