Index Probabilities

by Jay Pestrichelli on March 16th, 2012

Some of you are familiar with the out-of-the-money credit spreads we’ve talked about in the past. Our write up on this high probability / income generating strategy was featured in SFO Magazine’s March 2012 issue and can be read off our home page for those that are interested.

The metrics we use for this strategy usually involve knowing the probability of expiration at specific market levels and price of options. What many people don’t realize is that these same metrics can be used to get an idea of the options market forecast.

As the index options expire after the open today, lets look at the April expiration to see what the tea leaves are telling us.

Anyone with a decent options platform should be able to get probabilities right off the option chain provided by your broker. The chain will tell you the probability that the option will be out-of-the-money (OTM) at expiration.

But confusion can set in when looking at the probabilities of calls and puts at the same strike. One would expect that if the probability of the S&P closing above 1300 (approximately 7% below the Thuraday close of 1402) would be the same for both the calls and the puts. But they can be “skewed”. This is a term used to show some bias between the calls and puts.

Lets look at the actual closing data to illustrate this:
In this option chain, the probability that the 1300 puts close OTM is 88.1% and the probability that the 1300 calls close OTM is 6.25%. Said another way, the option chain is telling us that there is a probability between 12% and 6% that the market will close below 1300 by the April expiration. Lets take the mid-point of 9% to make this a little easier.

One would expect that if the puts probability to end OTM was 88% than the calls should be 12% (100%-88%), so why is this the case? These probabilities are driven by the price of the options. More specifically, probability is driven by the extrinsic value of the options which technically rolls up time, volatility and interest rates. But in reality, it really sums up what someone is willing to trade the option for.

If options are more expensive evaluated by extrinsic, it means there is a bias that that option will go in-the-money (ITM). Or said another way, it means that there are more buyers of that option than sellers. In this example, The extrinsic of the put is $4.65 compared to the call extrinsic that is $2.30.

This tells us there are more buyers of puts at the 1300 mark than buyers of calls. It can also mean there are more sellers of the calls at 1300 than sellers of the puts. It works both ways. Sellers can drive the price down just as easy as buyers can drive the price up. Either way, it can indicate a bias.

As a review selling calls is bearish like buying puts. Conversely buying calls and selling puts is bullish. The chart below can help keep that straight:
So based on the selling of call or buying of puts, we interpret this a sign that the market to go down, right?

It’s too early to tell this, as this is only half the equation. In order to get the whole picture, you’ll need to look at the other side of the market to make the comparison. Lets look at the 1505 level to see what that is telling us to get an idea of the probabilities equally away. We chose this level as it is the approximately the same amount away from the close of 1402.

Here’s a snapshot of the data at the close on Thursday
The calls have a 96.8% of ending April OTM and the puts a 8.58%. The option chain is telling us that there is a 3% to 8.5% chance that the market ends above 1500 by April expiration. Again, lets use the mid point of 6%.

Notice that the price of the call and put options at this level is much less. The calls are gong for 0.725 of extrinsic and the puts are going for $2.80. This is driving the probabilities down.

Compare this back to our earlier data where the option chain told us that there was a 9% the SPX would close down 7% below 1300. This is against a 6% chance the market moves up 7% and closes above 1505.

Now that we have both sides of the probability data, we can make the determination the market is forecasting a higher probability that it goes down 7% vs. up 7%.

Here comes the big warning! Be careful at looking at only one data point as you use this information. Find a tool that will do a roll up of all these data points for you before using this information to trade on. You may find that the results can be dramatically different.

Also, please remember probabilities is only one half of the risk / reward weighing. You'll see that the market in this case is giving more money for the lower strikes than the upper. Keep in mind the rule we've said here before, buy when options are cheap and sell when expensive...but that's a blog post for a different day.

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