The chance that the price of an underlying will be equal to or beyond a given strike price prior to expiration is known as the probability of touch (POT). It is roughly 2x the probability that the same strike will expire in-the-money (ITM), which is represented by delta. This can be tested by calculating how often either strike of a Standard Deviation Strangle is "touched" or breached, compared to how often it expires ITM.
Our research team conducted a 20 year study in SPY (S&P 500 ETF). We examined how often a one Standard Deviation Strangle expired in-the-money (ITM) or touched either strike before expiration. Options theory tells us to expect either the put or the call in our short strangle to expire ITM 32% of the time based upon the combined deltas. Implied Volatility (IV) overstated the chances and the strangles in our study expired ITM fewer times than what the numbers would suggest. The POT though was about twice the number of strangles that expired ITM.
Negative theta (time decay) and the chance that IV might contract work against the idea of buying a cheap option and then selling it when the strike is touched. Two examples were shown to demonstrate this.
For more information on probability of touch see:
Market Measures on September 15th, 2015: “Probability of Touch”
Market Measures on January 4th, 2016: “Probability of Touch After Touch”
Best Practices on February 22nd, 2016: “Best Practices Around Probability of Touch”
Market Measures on April 8th, 2016: “Probability of Touch | Realistic Expectations”
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of probability of touch and its ramifications for trading.
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