As an options trader, I’ve never understood why professional “talking heads” rarely, if ever, mention the topic of probabilities.
Wouldn’t you prefer to know the probability of a stock hitting a certain price? It certainly seems logical. Yet, I rarely hear investors, professional or otherwise, talk about statistics of any kind. It’s unfortunate.
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We always hear the brief analysis about a stock, the analyst’s target price, but never the probability or a timeframe of the stock they are advising people to buy actually hitting the proposed price.
Just look at Netflix (NFLX). According to The Wall Street Journal there are currently 40 institutional analysts following the stock. With the tech stock trading at 489.32 the average price target is 615.69 with a high of 1,154.00. The high price target, which is roughly 135% above where NFLX is currently trading, was issued the week of May 8. Of course, no timeframe was given as to when the analyst predicts NFLX will hit the predicted price.
While it’s great to have an understanding of the company you are potentially investing your hard-earned money in coupled with an arbitrary price target, does it really equate to making money? And isn’t that why we invest, to make money?
This is why, an as options trader I take a quantitative approach to the market.
I want to know what the probabilities are of a stock going to a specific price before I put my money to work. More importantly, I want to know exactly how much I stand to make and stand to lose so I can manage my risk accordingly. I’ll discuss managing risk through the use of various options strategies at another time.
Let’s focus on the probabilities of NFLX hitting the average price target of roughly 616 and the high price target of 1,154.
Probability of Touch
The probability of touch may be a new concept to some investors/traders, but it certainly isn’t to those that trade options. The probability of touch tells us the probability of an underlying stock touching a specific price over a specific timeframe. For example, look at the probability of NFLX touching 615 over the next 70 days, 224 days and 644 days.
Probability of Touching 615 Over the Next 70 Days
As you can see above the probability of NFLX hitting the 615 strike prior to the August 20 expiration in 70 days is only 9.23%.
Probability of Touching 615 Over the Next 224 Days
The Probability of Touch increases as a stock’s option expiration increases. It makes perfect sense, right? An options expiration date that is further out in time gives the stock more of an opportunity to hit the stated strike price.
And as you can see, the Probability of Touch increased from 9.23% in our August 20 expiration date example above to just over 29.59%. There isn’t a 615 strike available, but you can clearly see the 610 strike offers a 32.87% Probability of Touch and the 620 strike a 29.59% Probability of Touch. So, my guess is the Probability of Touch in the next 224 days is roughly halfway between the 610 strike and 620 strike, or 31.23%.
Probability of Touching 615 Over the Next 644 Days
It is only when we go out to the March 17 2023 expiration that the Probability of Touch pushes above a coin flip.
But what about the analyst who gave a price target of 1,154? What is the Probability of Touch for NFLX hitting that price target?
Well, if we look at all the option expirations for NFLX and go out as far as we can in price, the highest strike offered is 900. And yet a professional analyst, someone who gets paid lots of money to do sound research, went as far to say that NFLX will hit 1,154.
Again, if we go out to the March 17 2023 expiration date for NFLX the Probability that NFLX will hit the 900 strike prior to the expiration date is a paltry 11.92%. So, the probability of NFLX hitting a price level of 1,154 is incredibly low. Most likely in the 1% to 2% range, if that high.
Overall, with price targets of 615 and 1,154 we, as investors, are left with essentially coin flips and lottery tickets. Maybe that’s why we never hear about the probabilities of price targets?
This is exactly why, again, as a professional options trader, I take a quantitative approach to the market.
I want to know the probability of a stock or ETF hitting a specific price target over a specified period of time. By knowing this information, I have the ability to not only choose a variety of options strategies, but I also have the ability to choose the probability of success for each and every trade I place.
That’s right, we all have the ability to use options strategies that allow us to choose our own probability of success…in real time. That’s powerful! And as an investor, or options trader, we need to harness this ability by expanding our arsenal of investment/trading strategies we use on a regular basis.