Understanding Options Trading: Part One Probabilities.
Hello, I trade options and I am often asked if trading options is gambling? I think it’s a fair question given the mystery and reputation of options. I think the answer is sometimes. But I usually add “all investments are like gambling” “but some investments make you feel better about your investment then others, while some have a higher probability of success then others, but these two characteristics don’t always go together.
Let me explain. In a purely mathematical sense, all investments have a mathematical probability of success based on the number of possible outcomes. Because in math all outcomes have an equal chance of occurring. For instance, if you buy gold tomorrow, you are hoping that in the future the price of gold goes up. But what is the probability that the price of gold will go up and you will make money?
Well to answer it in math terms, you first ask what are the possible outcome?
The outcomes are:
- The price of Gold goes up.
- The price of Gold goes down.
- The price of Gold stays the same.
In general each of these has an equal probability of occurring. So, if there are three possible outcomes, and the probability of each occurring is equal, then the probability of each occurring is one out of three.
So in math terms:
- The probability of gold going up is one out of three, 1/3 or 33%
- The probability of Gold going down is one out of three, 1/3 or 33%
- The probability of gold staying the same is one out of three, 1/3 or 33%.
But that’s just half of what you need to understand about probabilities, like a coin has two sides heads and tails, or in this case up or down, probabilities have two sides. If the probability that the price of Gold will go up is one out of three, 1/3 or 33%, then then probability that gold will not go up, is the other side of the coin, which is the sum of the other two probabilities; 1/3 or 33% probability of staying the same plus 1/3 or 33% probability that it will go down, added together they equal 2/3 or 66% probability that gold will not go up, because it stays the same or goes down.
Let’s look at the math:
All three possible outcomes have an equal chance or 1/3. While 1/3 is the probability that gold goes up. So 2/3 is the probability that it stays the same or goes down. So if there is a 33% chance Gold will go up, there’s a 66% chance it won’t. So is investing in gambling? Yes, in truth all investments are gambles. Your job as an investor is to put the probabilities of success on your side.
How do you do that?
Either by doing the math or finding sources of information that have done the math for you, so using your understanding of probabilities you invest in things which have a higher probability of success then failure.
When we invest in options, we have the ability to calculate our probability of success. But that subject is for another post.
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