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Probability of Profit (POP): Is It Important…. Yes!

Options Trading 101 - The Ultimate Beginners Guide To Options

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by Gavin in Blog

There is no shortage of indicators around in the trading space. One of the favorites investors like to use is Probability of Profit (POP).

What is Probability of Profit?

Probability of profit is the odds of a particular options trade making money.

Simply put if I make an options trade and do not manage the position how often will I be profitable.

This is not to be confused with the probability of an option finishing in-the-money (ITM).

Remember an option can end up ITM and the buyer can lose.

This is so long as the premium outweighs the amount the option is ITM.

Calculating Probability of Profit

Depending on the options trade structure you have on, calculating the probability of profit will be different.

If you have a Tastyworks account or a few other brokerages this number is calculated for you as per the chart below.

While these numbers will not necessarily spit out a perfect probability of profit it works out to be a pretty good approximation.

Do you want a High Probability of Profit? Sell Options

The easiest way to have a probability of profit is to sell options.

Remember an options seller is like an insurance provider.

They will always collect their premiums, rain or shine.

They will only pay out when there is a storm.

So naturally the odds of paying out are not that high.

A further factor is that market distributions do not follow a normal distribution curve.

This means that even more often than normal distributions predict we have nothing happen.

This adds to the percentage of profit for options selling, though make the tail losses very costly.

Want to increase your POP even higher?

Simply move further and further out-of-the-money in the options you sell.

Source: Nasdaq

Why Probability of Profit Doesn’t Matter On It’s Own

I often hear traders explain the merits of a trade using probability of profit.

“I like trades with at least 80% POP” they say.

This is the opposite of traders who explain the merits of their trade using risk to reward.

“Risk 1 to gain 10, sounds juicy!”

Neither of these things, probability of profit, nor high risk to reward of a trade, equate to expected value.

Imagine you at a Casino in Las Vegas.

You are at a roulette table and put all your money on #17.

Risk 1 to pay out 35, a very good risk to reward ratio.

Conversely imagine playing bets on all the numbers except #17 & 18.

Now you have a very high probability of profit.

In both cases you are still playing a losing game at the casino.

No matter how you place your bets it doesn’t change the game you are at nor the expected value of that game.

The same goes for investing.

A high probability of profit is a useful tidbit but alone it doesn’t make a trade a good one.

Just like a high risk to reward sounds appealing, but only truly is if you think the market is undervaluing the odds of the event happening in the future.

Despite the best risk to reward ever created there is a reason why investment advisors don’t buy their clients lottery tickets.

Psychology

There are some major psychological reasons why investors lean towards trades with a high probability of profit.

The foremost is loss aversion. Nobody likes losing money and investors will do whatever it takes to avoid it.

This ranges from holding a losing position to avoid realizing losses to not a short volatility position.

High percentage of profit trades are the perfect vehicle to satisfy this need for loss aversion.

Despite this if you asked most investors if they would rather have small frequent drawdowns or large infrequent ones they will most likely verbally pick smaller more frequent ones.

Unfortunately, in the market, actions speak louder than words.

Many investors will conversely pick out high risk to reward trades.

This switches the mindset to “what if I win?” and the investor views the cost as a price to pay for that mindset.

Neither way is necessarily better or worse.

In fact, from a wholesome view a lottery ticket may provide a good feeling and dream that outweighs the negative expected value lost in the ticket.

Each individual is free to structure their trades how they like, just make sure you don’t equate preference to profitability.

How to Use Probability of Profit Successfully

While probability of profit isn’t useful as a standalone metric it is extremely important in betting and is an integral part of the Kelly Criterion, which measures ideal bet sizing.

Source: Sports Betting Dime

The great thing about the Kelly Formula is that provided you have all the variables it is a mathematical fact that over the long run it will maximize wealth vs. other methods.

As we can see here probability of Winning in P is an integral part of the formula.

Though of course simply having this alone is not enough, we need to know how much we win if we are right and lose if we are wrong.

We need to know our expected value.

Naturally, this is easier said than done.

In games such as poker and blackjack it is easy to calculate expected value, after all in a card deck there are only 52 cards. In the stock market it is not as easy.

While famous hedge fund managers such as card counter Ed Thorpe has had tremendous returns in the stock market though using expected value in their trading, it is not a cake walk.

As situations are often not binary the ultimate expected value calculation may be at best an estimation and without precise data should be taken with a degree of uncertainty.

Concluding Remarks

Probability of profit gives an approximation of the odds of making a profit on any trade.

It also provides an integral part of calculating the expected value for a trade.

While reliance on the probability of profit can sometimes be misused as a standalone indicator, it remains valuable as part of the process of trade evaluation.