Explained: How Do Odds And Probability Work In Option Trading? (Kirk‌ ‌Du‌ ‌Plessis‌)

In this episode, Robert talk to Kirk‌ ‌Du‌ ‌Plessis about how do odds and probability work in option trading.

Robert Leonard:
For those who might be new to options trading, can you explain where the odds or probabilities come from?

Kirk Du Plessis:
Yeah, so in options trading, it’s much different than a stock, because at a regular stock trade, everything that is known obviously about the stock, or is expected about the stock, is priced in. And there’s only one choice with a stock trade, you either buy the stock at the current price, or you sell the stock at the current price. There’s no future movement. You can’t buy the stock prematurely at a future price, and someday. Everything’s done on a cash basis right now. With options contracts, options contracts entertain two additional elements that make it more confusing and a little bit more complex to calculate, though, can be done.

The two additional elements are time. So option contracts can have various timelines, no different than when you buy insurance for your car or your house. You can write a policy or buy an insurance policy for six months, or a year or two years. Even my life insurance policies, there are 20 year terms, or 10 year terms. So the longer that you buy protection, the more expensive generally the contracts become. And that’s because they’re capturing a longer time period.

The second element that introduces a little bit of complexity into option pricing is the idea of strike prices. So strike prices, like we already talked about, our example, can be wildly different than what the stock is actually trading out right now. So if the stock is trading at $100, you could strike a deal. And that’s why I usually like to refer to the strike price as you striking deal with the other party at a price point that is much higher than where the stock is trading now, or much lower than where the stock is trading. So now that we have these two additional elements that are kind of baked into option pricing, we now have some sort of time factor. So how far out is the contract until it expires. And then we have a strike price, which is how high or low you know, or how much higher or below the stock price is the strike price of the option contract, like where it actually kicks in and starts to make money, or lose money or whatever. Now we have these two elements, we need to bring them all together in some sort of expectation of how volatile the stock is going to be. And so this is really where the probabilities are derived from.

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