Papale on Probability

I had the pleasure of traveling to Italy last week and aside from the obvious beauty and awesome food, we learned firsthand how much we Italians (yes I’m Italian) love soccer.  Growing up in the Midwest in the 70’s I played baseball, basketball and football (American that is).  And in my community today soccer is pretty popular with the kids but most adults don’t gather around the TV to watch a soccer game.  However last week when Italy played England and the game was broadcast live at 12 midnight, the bar at our hotel was packed.  And after Italy won the game the celebration rang loud in the streets of Milan near our hotel.  Kind of reminds me of how it will be when the Cubbies win the World Series.

Probability.  Options traders rely on this when placing and managing many types of trades.  Delta can be thought of as the probability of an option finishing in the money at expiration.  Statistically it is true that when we sell for example an option that has a 15 delta, it has a 15% chance of finishing in the money at expiration.  However, that statistical probability does not necessarily equate to an 85% profitability rate over time.  Let me explain.

If we sell the 15 delta call and forget it until expiration, 85% of the time we should see the call finish out of the money.   The call goes out worthless and we keep the premium.   What the statistics don’t factor in is adjustments that are made during the life of the option.  Say we sell the call.  If the stock rallies the delta may move from 15 to 25.  Of course our P and L will likely show a loss.  Depending on our trade management rules we may need to make adjustments during the trade which in effect turn unrealized losses into realized losses.  By doing this we move our risk profile back into an acceptable range.  Even if the stock falls back and the delta eventually settles at 0, we may incur overall losses on the trade.  So probability is only part of the profit story, trade management is the other part.   And remember too, that even if we don’t manage the trade and the statistics play out and we win 85% of the time, the overall P and L  of all the trades will depend on the severity of the 15% losing trades.  As some of us may know too well, a few large losers  can wipe out several small winners.

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