Narrator: Hello, traders, I'm Phil Carava. And in this video, we're going to walk through how to do probability analysis on the thinkorswim® desktop trading platform. Specifically, we're going to look at the Probability Analysis tool, which is found under the Analyze tab. Keep in mind, we’ll be looking at thinkorswim desktop—features may be different on thinkorswim web or mobile. Now to start the video, we're just going to kind of walk through the tool, how it's laid out, and where everything is located. And then we'll show you some examples on how you can do probability analysis. We're going to start simple and work our way to our more advanced example by the end of the video.
So, let's jump in to get started.
Animation: thinkorswim® desktop appears with Probability Analysis subtab under the Analyze tab open.
Narrator: To get started using the Probability Analysis tool, let's navigate to the Analyze tab and then the Probability Analysis subtab. We'll put in a symbol and, for this example, let's use Apple. Now as you see, as we did that, the probability analysis chart has been activated. Below that, we have a table of information. And then below that, two sections, one called Price Slices and the other Positions and Simulated Trades. We're going to focus on all these areas here in a second, but let's just focus on the probability analysis chart.
Now you can see we have some elements on the chart. We have the implied volatility of Apple listed here in the upper left-hand corner. Implied volatility is a percentage that represents the market's perception about how volatile the stock will be in the future.
The y-axis represents the price of the underlying stock, in this case, Apple. And then the x-axis represents days out into the future, so 10 days, 20 days. You'll notice that as I move my mouse throughout the probability analysis chart, a pair of cross hairs will follow my mouse and you'll see two numbers listed—a percentage above and a percentage below. Essentially, what this represents is a probability of Apple moving above or below a certain price by a certain date and time. You can turn these off by clicking this target button here at the top of our menu. I'm going to leave that turned off for now because I want to discuss some of the data that we're seeing on this analysis chart.
The first thing I want to focus on is the vertical dashed lines. These are the options expirations for Apple. Now the prices you see horizontally listed here. We have one line here dead center of our chart. Then we have one above, one below. These are our price slices. So, if we look down here on our page, we have first, the middle price. This is the current price of Apple. And because the padlock is open, this price will float automatically as the market moves up and down. Now the two levels above and below by default will represent a 10% price level above the current price and a 10% price level below the current price. These padlocks are also open, so as the price moves up and down, that 10% value will move up and down with it.
Now what about this probability analysis graph? Well, very simply put, this is the one standard deviation move of Apple, up or down, at any given options expiration date. Standard deviation means how much a stock price has deviated from its average price over time. So you can see up here, we have this probability range of 68.27%. That is set to a one standard deviation move. Now these prices are being calculated off of the implied volatility of Apple and the options-pricing model.
OK, so how do we actually start using this to analyze scenarios and analyze probabilities? Well, we're going to start with a few different examples and we're going to start simple, kind of work our way into a more advanced example later in the video.
But first, let's start with a basic stock trading example. Let's imagine you were thinking of buying shares of Apple, but you only want to buy it if it gets down to $135. Well, let's queue up that order, and that would be a limit order, and it would be below the market. So, I'm going to type in $135. So now you have to ask yourself: What is the probability of Apple trading down to $135 anytime soon? Well, if we go to our Analyze tab and Probability Analysis, and we find that $135 price level, we can do this one of two ways. We can use our mouse or we could just set a price slice of $135. I'm going to do that on my lower price slice. As I type that in, you can see that this padlock is now locked, meaning it won't float with the current market. It will stay at that level. And now if we find that $135 price level, you can see at any given point as we move our mouse out in time, those percentages will start telling us what's the probability of getting to or below $135.
Well, in this case, the odds aren't looking great. You can see we have roughly, we'll call it, a 2% chance of Apple getting to that price level anytime soon. Now as time goes out, you can see our odds increase. Now this is where we also use this table, you can see the odds of Apple getting below $135, which would fill our limit order, as we go on and the option expiration dates, you can see that the percentage increases, but we really don't have a great chance of getting filled at $135 anytime soon, even if we go out to July.
OK, for our next example, let's take a look at a scenario of buying a long call. What's the probability of being successful on a long call purchase on Apple? Well, the first thing we do is we're going to look at the Trade tab. Let's take a look at the March options, which have 37 days left. I'm going to click that open. And let's imagine we thought Apple had a chance to keep going up and we were thinking about buying, let's just say, the 160 call. Right now, it's trading for about $2.50. What's our probability of being successful on this trade? Remember that when looking at probabilities, the calculations are based on theoretical pricing models and the inputs into the model. We’ll be looking at the default inputs but remember you can adjust those based on your forecasts for the stock price and other variables like time and volatility.
Well, there are ways on the option chain to assess your probabilities. And real quick, let's pop those in. I'm going to change these two columns. The first one, I'm going to change last price to Probability of ITM or in the money. And I'm going to change this column to Probability OTM or probability of out of the money.
Now what are these numbers telling us? Well, if we look at our 160 strike and we go over to probability of in the money, because we're thinking about owning this call, we want it to be in the money by expiration, which would mean Apple would need to be trading at least one penny higher than $160. So $160 and one penny, what's the probability of trading at that level or higher by expiration in 37 days? Well, the options are telling us that it's only about a 28% chance. So you can see just off the bat, getting to and staying above our strike by expiration, we only have about a 28% chance of that happening.
However, remember, if you're purchasing a long call, you actually have to factor in what you pay for the option, which is your break-even point. So, we would take 160 and we would add this $2.51 option price, which means our break-even is actually $162.51. Now you can see we don't have that price level here on the option chain, so we can go over to the probability analysis tool—and remember, we were looking at the March 17 options—and we want to know what's the probability of Apple getting above $162.51, which would be our break-even point, where we even start to make money on this option at expiration. There's that expiration here on our chart. And we're going to go up to the $162.51 price level. So, there you see we have roughly only a 25% chance of breaking even on this trade by expiration. Now if you're comfortable with those odds and you're willing to take the risk of paying the option premium to have a one-in-four chance of making money on the trade, then that would reflect your forecast that Apple has the potential to defy the probabilities and move above the break-even point. However, just looking at probabilities, you would have a 75% chance of not succeeding in this trade.
OK, for our next example, let's show you how to sell a vertical call spread and analyze the probabilities on it using the analysis chart and the data associated with it. So, I'm going to go to the Trade tab and we'll use the same March expiration that we did on the long call example. Now remember, as we were looking at this 160 strike—I'm just going to highlight real quick—you can see we assessed that there was roughly a one-in-four chance of this option being in the money by expiration, which, if we think about it logically, says that there's a three-in-four chance that this option will be out of the money by expiration. And if you're the seller of an option, those may appear to be good theoretical probabilities. So, maybe we want to sell that.
Now a naked short call has unlimited risk. So, let's attempt to limit that risk by buying the 165 call and turning this into a short vertical spread. Now our bias on this trade is that we are bearish. We are hoping that Apple stays below $160 by March expiration in 37 days. And in doing so, we'll just lock that in at $1.15. We'd be collecting $1.15 to sell the spread. The max risk on this trade would be the five-point-wide spread minus the credit. So basically, our risk would be $3.85 just to be making $1.15.
So, one, what's our probability of being successful, and two, what's our probability of at least breaking even on this trade? Well, we're going to do the same analysis we did with the long call.
First, you can see the 160 call here tells us exactly the probability of Apple trading at $160 or lower is roughly 72%. Now those are pretty good odds. Now what's the break even on a trade like this? Well, if you know your options, you would take your short call, which is the 160 call, and we would add the $1.15 that we're collecting for a break even of $161.15. Now you can see we don't have that $161.15 price listed on our option chain, so we have to go over to the Analyze tab. And now, same thing we did before—we're going to go to that March 17 expiration. Let's find our break-even point of $161.15, and we'll get as close as we can to that price level. There you can see we have roughly a 70% chance of Apple staying below our break even, and about a 30% chance of breaching it and trading above.
Now one other thing I want to show you is the Positions and Simulated Trades section. In this area, we can actually put in an existing position or a simulated position, maybe something you're thinking of putting on, and we can analyze the probabilities of being successful or not based on different factors. And we can tweak those factors to create different scenarios and then see how the probabilities change based on those factors.
So let me show you what I'm talking about.
The first thing I'm going to do is I'm going to go to my Monitor tab, and we'll look at this ExxonMobil position because we are short one put. We're short a February 110 put, which has nine days left until expiration. We sold the put for $0.93. It's currently trading for $0.84, so we've made some money on this put. And we can see because the stock price is trading well above our short put strike—right now, the stock's at $114.40, and we're short the 110 put, so this option is out of the money. It's lost a little value, and because we sold the option, we're profitable at this moment. But what can happen? Well, the price could go down, volatility could go up. And as time goes by, theta is going to decay, and this option is going to lose value based on time. So different variables are going to affect the price of our option. And with that, the probabilities of this option being in or out of the money will also differ.
So, let's take a look at our Analyze, Probability Analysis tool. And you'll notice because we have a position in XOM, this field below position and simulated trades is populated with some data. If you see both items check marked, maybe at multiple positions, make sure you only check mark the option or position that you want to analyze. So, in this case, we have our February 110 put, which we traded for $0.93. And let's just look at the probability analysis graph as if nothing were to change at this moment. We just want to know right now at this point in time what's our probability of keeping the premium that we received on this position.
And the first thing I'm going to do is change the probability mode. And you can see there are three different probability modes—in the money, out of the money, and touching.
Animation: A dropdown under Probability Mode shows three options: ITM, OTM, and Touching. Then crosshairs appear as the curser hovers over the probability analysis chart.
Narrator: Really quick, what's the difference? Well, probability of in the money—if you notice when I hover my mouse—once again, there's a number above and below our crosshairs. That number above is going to be the probability of a call option being in the money. And the number below is going to be the probability of a put option being in the money. And when we hover over that $110 price level, which is our short put, and we go out to our February expiration, you can see that we are essentially right, actually, near that probability distribution curve. But to be more specific, there you go, we have roughly a 24% chance of this option being in the money.
Now if we were the owner of this put, that number would be valuable to us, but because we are the seller of this put, we want to know the odds of this option being out of the money at expiration. So, when we switch from probability ITM to OTM, you'll see those numbers inverse. So, when I go to that $110 price level on our expiration date, you will see that we actually have a 76% probability of keeping this premium because, once again, we sold the option. And we want this to go out worthless and be out of the money. So, by changing the probability mode to out of the money, we can see, all right, that lower number is telling us that we have roughly an 80% chance that this option will remain out of the money.
Now, what other type of analysis can we do with this section? Well, if we go back down, you can see right here, we can adjust the date. So that means we can just assume stock price doesn't move, volatility doesn't increase or decrease, but time goes by. And we're going to go ahead and let's just move ahead a few days. Now let's go back to the probability analysis graph. And you can see our February 17 expiration has moved closer to that zero day because we've advanced time. And we're going to go to February 17 and we're going to find that $110 price level. And you can see our probabilities have increased about 5% that this option will remain out of the money just if time advances, everything else staying the same.
Now let's make some more adjustments. We can click this gear wheel. And you can see now we have two new fields: Volatility Adjustment and Stock Price.
Well, let's say Exxon sells off three bucks in the next week. Time has gone by, and we've lost $3. Let's say it goes down to $111. Well, that's not going to be good for our position because now our short strike is starting to get threatened and we're still not at expiration. So, if we go to our options graph or our probability graph, and we put our mouse on the expiration and find $110, you can see now we have roughly a 58, 60% chance of this option being out of the money. Still, the odds are in our favor, but now we're well within the standard deviation distribution curve. And that's because the price has reduced and now our short strike is getting close to being threatened.
Now finally, what if volatility changed? Because you would expect that if price dropped like that so dramatically in a short period, you would see that maybe volatility will increase. And as the seller of an option, that's not good for you. So, what if we made this an 8% increase in implied volatility? Now, let's go back to our graph one more time, and I want to put my mouse on the line and find $110. Now you see we’re even further inside that distribution curve. And now we're talking about a 56% chance of that option remaining out of the money. So not a huge difference, but you can see as volatility increases, we would then be worried about the price of our option increasing as well.
And finally, if you just want to reset everything get back to your default settings, you can click this action menu in the upper right-hand corner, make sure it's the top one. And you're going to hit Reset. This will ask if you want to reset the system to default and any unsaved adjustments will be lost. You hit Yes. And now everything will go back in terms of your date, your volatility, your stock price, as well as the price slices.
And that's a quick look at the probability analysis tool in the thinkorswim desktop trading platform. Now remember: Probabilities and probability analysis is theoretical in nature, which means the outcome of those probabilities are not guaranteed and do not reflect any certainty of an event occurring in the future. So, keep that in mind. And remember, if you're looking for more in-depth walkthroughs and tutorials on the thinkorswim trading platform, head over to the thinkorswim learning center—see the link in the description. For more great content and investor education, check out Insights & Education on schwab.com. And subscribe to our YouTube channel to get notified when we release new videos. So, thanks again for watching and happy trading.
On-screen text: [Schwab logo] Own your tomorrow®
