Improving Your Results With Options

Options are instruments of probability. They are priced using a complex mathematical formula which boils down to the measurement of two variables:  (1) Intrinsic value (or how much “in the money” it is), and (2) ‘Time and Probability’ value (most commonly just known as time value).  Understanding these two variables is key to trading options profitably.

Far too many traders lose money simply because they don’t understand how market makers adjust option pricing in their own favor. The following simple truths about option pricing will help you recognize where option prices are likely to end up, and the probabilities associated with that final outcome.

1. 1. Option prices are set by option market makers.
   2. Options are priced so they decrease in value more often than they rise.
   3. The option market maker adjusts the time value of the option to make it likely they’ll win 70% of the time.

Because these concepts are true, they lead to three important trading corollaries:

1. 1. Option sellers have a higher probability of winning but are guaranteed smaller profits in comparison to the risks they take on each trade.
   2. Options buyers profit only if the underlying rises fast enough for the intrinsic value part of the option’s price to offset the loss of time value as time passes.
   3. Option buyers have a lower probability of winning compared to option sellers, but make much larger percentage gains when they do win.

This lesson will explore each of these simple truths and their corollaries to help you understand how you can use the probability profiles and trading edge you learned in previous lessons to maximize profits in your option trading.