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February 9, 2011 - by Christopher Smith
  
Why Probability of Success or Touching Does Not Work

Probability of Success and Probability of Touching studies can both be valuable tools, but it is important to recognize that they have significant limitations and that they cannot be relied upon to accurately quantify the true probability of a trade returning a profit or, even more importantly, avoiding a crippling loss.

Probability of Success (POS) is an analytic metric that attempts to calculate the probability an option will be out-of-the-money as of its expiration date. This analysis allows an option trader to sell options or option spreads that have a relatively high probability of expiring worthless.

In similar fashion, Probability of Touching (POT) estimates the likelihood of the market reaching the strike price of an option prior to the expiration date. Markets oscillate, moving up and down. It is not uncommon for the market to move higher or lower, reaching the strike of a previously out-of-the-money option only to reverse course and leave that option out-of-the-money once more.

These market oscillations are responsible at times for creating enough fear that the option seller buys-to-close their short option positions, locking in a loss only to see the market reverse course. It is the frustration of experiencing these market "whip saw" moves that has some option sellers looking to the probability of touching metric.

Both of these measurements attempt to provide the trader with expectations of what to expect in terms of price movement in the market from the present time until the expiration date. The probability of touching measurement will simply provide more room for market movement since it must accommodate the peaks and valleys of market oscillation.

The problem we encounter with both of these studies is that their projections of price movement are based upon a forecasted volatility for the underlying security. This "forecast volatility" must account for the actual volatility that will occur in the market between now and the target expiration date. Of course, we have no way of knowing what will happen in the future so we do not know what the actual volatility will be during the coming days.

Markets are not static creatures. There are times when the market adopts a calm, slow moving pace. At other times the market will thrust higher and quickly drop lower. This later description portrays rather volatile price action while the former suggest very little volatility. Perhaps it is ironic, but in both scenarios the finishing price might be precisely the same. The finishing prices could also be quite divergent.

Our metrics need to take the volatility of the market into consideration. If they assume a low volatility environment they will forecast a relatively tight price pattern. The projected price pattern will broaden with an increase in the volatility forecast. If that forecast correct, you have an infallible machine. The trouble is that the forecast is never correct.

The effectiveness of the POS and POT studies depends upon the accuracy of the volatility forecast. Most often the forecast value is derived from either calculating the actual volatility of the market over a recent period of time or relying upon the implied volatility obtained from the option chain of the underlying security.

Historic volatility assumes that the market's actual volatility from the present time to the target expiration date will conform to the recent market price action. If our target expiration date is thirty days in the future we might calculate the volatility of the market over the preceding thirty days or so, and use the resulting figure as our forecast volatility for the upcoming thirty days. The weakness in this approach is that markets can and do change their character, so a historical measure is likely to either over or under estimate the actual volatility over the next few weeks.

The implied volatility from the underlying security's option chain is a reflection of the consensus of opinion that exists among market participants. Option prices are bid higher or lower based market participants' expectation of what is likely to happen with the underlying security. If the expectation is for a potentially large move in the price of the underlying security, option prices will rise ahead of that anticipated move. Options prices fall when the market's fear of a drastic price move subsides.

Relying upon the implied volatility is placing faith in the market to "get it right." The market often will, but not always. All market participate are blind when looking into the future. No one knows what tomorrow brings.

Probability of Success and Probability of Touching rely upon accurate volatility forecasts. The two primary methods are to essentially take a "look in the rear view mirror" to see what the market's behavior has been in the recent past or to rely upon the collective prognostication of all market participants. Both methods possess flaws.

This does not mean that the POS and POT metrics are without value or that they do not have their uses. Both can be valuable tools. Nonetheless, it is important to recognize that they have significant limitations and that they cannot be relied upon to accurately quantify the true probability of a trade returning a profit or, even more importantly, avoiding a crippling loss.