The Probability of Price Targets—and How They Can Lead to Better Investment Decisions

how-options-trader-uses-probability-of-touch-nflx-calls

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.

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.

price-target-netflix-NFLX

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

probability-of-touch-august-2021-calls

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

how-options-traders-use-probability-of-touch-january-2021

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

how-options-trader-uses-probability-of-touching-march-2021

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.

how-options-trader-uses-probability-of-touching-march-2023-nflx-calls

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.

 

4 comments on “The Probability of Price Targets—and How They Can Lead to Better Investment Decisions

  1. Ahmad on

    Very informative article. My question is how we use probability of touch to make decisions about the price targets we are looking when trading options? How best we can make use of the probability of touch together with high probability of success of trades ( over 75-80%) in our trades? Will appreciate your comments on this aspect? Thanks

    Reply
  2. Andy Crowder on

    Ahmad,

    Thanks for the kind words. Glad you found the article informative. I use probability of touch in it a variety of ways, but my main focus for probability of touch is when I enter a trade. I, in most cases, like to have a probability of success typically over 80% when I intend to place a conservative approach (from a probabilities perspective). So, I prefer to have a probability of touch below 50%, preferably in the 30% range when opening a trade. Afterwards, as the position moves closer and closer to expiration, I keep a close on eye on probability of touch to see where it’s sitting, again preferably below 50%. If not, well, I need to reevaluate the trade to see if any adjustments need to be made. When using a high-probability strategy I want to make sure I’m never, intentionally, putting myself into a coin flip situation. I hope this helps.

    Reply
  3. Ahmad on

    Thanks Andy. So, it is a combination of 80% probability of success with a less than 50% probability of touch – preferably between 30 and 40%, that should result in successful sale of credit spreads.
    Perhaps, the duration of trade is also important, because these probabilities change with the changes in the underlying prices and a longer duration might help, if these probabilities go beyond our expectations and then they can revert back within profitable range in the near future.

    Again thanks so much. I do greatly appreciate the time you take to answer our questions.

    Reply
  4. Andy Crowder on

    Ahmad, that’s my preferred approach and what I have found useful as a foundation for my trading. There are obviously other approaches as well. Risk-management combined with a sound statistical approach is the key to long-term success. Duration can be important, depending on levels of implied volatility (IV) and other varying factors that I will cover in some upcoming videos that will be posted. The law of large numbers, with the exception of sequence risk, should be anticipated when trading (coin flip example). But again, you must be disciplined in your approach and allow the law of large numbers to work itself out. Hope this helps.

    Reply

Leave a Reply

Your email address will not be published. Required fields are marked *