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If you’re an options trader like me, you know that we have tremendous leverage trading options versus stocks. But unless you understand options trading risk management, that leverage only goes so far. When combined, probabilities, delta, volatility, and time to expiration are factors that will give you a better chance of winning big and losing smaller amounts of capital.

If you’re new to options trading, you can’t just wing it. I don’t know of anyone who can make a living by placing trades with low probability of profits. You might as well gamble in a casino. You need a process that consistently positions you to make money or lose less money if a trade does not work in your favor.
 

Probabilities are crucial to options trading risk management

An option has a probability of making it to the strike price. Some traders call the delta a probability, though the textbook definition is not as precise. (The delta measures how much an option’s price can be expected to move for every $1 change in the price of the underlying security or index.)

Deltas are unique for each strike based on expiration. For our purposes, the higher the delta, the better the chances that stock will hit a strike price before the option expires. Therefore, there is intrinsic value in a call option if the stock price is above the strike price. This is called “moneyness.” If the stock price is below the strike price, then the only value in that option is time.

If you’re going to buy time, you’re trading on the hope that the stock price moves faster than the option price. (This is called gamma, or rate of change in delta – something we will talk about in a later blog article.)

Before we get knee-deep into statistical terms, buying a higher probability option allows you to stay with a trade for a longer period, even if you give up some leverage. If you’re scratching your head wondering what I just said, let me explain.
 

Here’s how it works in real life

Let’s say Amazon (AMZN) is trading at $138 per share. You think the stock may move higher, so rather than buying shares, you buy call options for the leverage. You have many strike choices to choose from, but let’s compare an out-of-the-money $140 strike to an in-the-money $135 strike, six weeks out. The 135 strike costs $7.65 per contract, or $765 for one stock. The $140 call strike costs $4.85 per contract, or $485 for one stock. The difference in stock price is $280, and most of that differential is due to time.

What are the probabilities Amazon will be above each strike price in six weeks? The 135 strike has a delta of 62% while the 140 strike carries a delta of 48%. (Delta can be found on any basic options trading montage.) So now we know that the 135 strike has a better chance of making it through 135 in six weeks. The 140 call still has a chance to make it, but it’ll require a bit more heavy lifting since it is out of the money.

Additionally, the 140 call at 4.85 has ZERO intrinsic value, but the 135 call has $3 of intrinsic value. The value of both calls will decay in a similar fashion, but the value of the 140 strikes will move faster to the downside if the stock remains stable or even drops a bit. Therefore, the 135 strike has a better probability of hitting or passing the strike price.
 

TL/DR

Clear as mud, right? (If you need an overview of options trading basics, you can find it here.)

When all is said and done, the safer trade is in the money with the higher delta. Of course, you still have to wait for the outcome. If it’s in your favor, then you manage the profitability and risk by taking profits when you have them.

In our next blog post (part 2), I’ll dive into the role that volatility and time to expiration play in managing your risk.

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