There is no shortage of indicators in the trading floor. One of the favorites that investors love to use is Probability of Profit (POP).
This article describes what probability of winning is. We will then talk about its usefulness and limitations in Trading options.
The probability of winning is the probability of a particular option trade earn money.
Simply put, if I make an options trade and don’t manage the position how many times will I be profitable.
This is not to be confused with the likelihood of an option ending in the money (ITM).
Remember that an option can lead to ITM and the buyer can lose.
This applies as long as the premium outweighs the amount of the ITM option.
Depending on Options trading structure You have on, the calculation of the probability of winning will be different.
If you have one Tastyworks Account or some other brokers, this number will be calculated for you according to the table below.
While these numbers don’t necessarily spit out a perfect probability of winning, they prove to be a pretty good approximation.
The easiest way to have a probability of winning is to Sell options.
Remember that an options seller is like an insurance provider.
They always collect their premiums, regardless of whether it is rain or shine.
You only pay out when it storms.
Therefore, of course, the payout chances are not that high.
Another factor is that the market distributions do not follow a normal distribution curve.
This means that even more often than the normal distribution predicts that nothing will happen.
This increases the percentage of profit for option sales, even though the Tail losses very expensive.
Do you want to increase your POP even further?
Just keep moving broke in the options you are selling.
I often hear traders explain the merits of a trade based on the probability of winning.
“I like trades that are at least 80% POP,” they say.
This is the opposite of traders who explain the merits of their trade in terms of the risk / reward ratio.
“The risk of winning 1 by 10 sounds juicy!”
Neither the probability of winning nor the high risk of winning a trade correspond to the expected value.
Imagine you are in a casino in Las Vegas.
You are sitting at a roulette table and wagering all your money on # 17.
Risk 1 up to the payout of 35, a very good risk / reward ratio.
Conversely, imagine betting on all numbers except # 17 and 18.
Now you have a very high probability of winning.
Either way, you are still playing a losing game at the casino.
No matter how you place your bets, it will not change the game you are in or the expected value of that game.
The same goes for investments.
A high probability of winning is a useful tidbit, but it doesn’t make a trade a good one on its own.
Just as high reward risk sounds tempting, it is only real if you believe the market is underestimating the likelihood of a future event.
Despite the best risk of return ever created, there is a reason investment advisers don’t buy their clients lottery tickets.
There are several major psychological reasons why investors tend to trade with a high probability of winning.
First and foremost is loss aversion. Nobody likes to lose money and investors will do everything possible to avoid it.
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This ranges from holding a losing position to avoid losses to Delta hedging a short volatility position.
A high percentage of profit trades is the perfect vehicle for satisfying this loss aversion need.
However, if you ask most investors whether they would rather have small frequent drawdowns or large infrequent drawdowns, they will most likely verbally choose smaller, more frequent drawdowns.
Unfortunately, actions speak louder than words in the marketplace.
Conversely, many investors will choose high risk to reward trades.
This changes the mindset to “what if I win?” and the investor views the cost as a price to be paid for that mindset.
Either way is not necessarily better or worse.
In fact, from a healing point of view, a lottery ticket can convey a good feeling and a dream that outweighs the negative expectation value of the ticket.
Anyone can structure their trades however they want, just make sure you don’t equate preference with profitability.
While the probability of winning is not useful as a standalone metric, it is extremely important in betting and is an integral part of the Kelly Criterion, which measures the ideal bet size.
The great thing about Kelly’s formula is that, assuming you have all of the variables, a math fact is that in the long run it will maximize wealth when compared to other methods.
As we can see here, the probability of winning in P is an integral part of the formula.
While having that alone is of course not enough, we need to know how much we gain when we are right and how much we lose when we are wrong.
We need to know our expected value.
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Of course, that is easier said than done.
In games like poker and blackjack, the expected value is easy to calculate, after all, there are only 52 cards in a deck. It’s not that easy on the stock market.
While famous hedge fund manager like card counter Ed Thorpe, has made tremendous returns on the stock market despite having used expected value it is not child’s play in their trading.
Since situations are often not binary, the calculation of the final expected value can at best be an estimate and should be done without accurate data with some uncertainty.
The probability of winning gives an approximation of the odds of winning a trade.
It is also an integral part of calculating the expected value for a trade.
While reliance on the probability of winning can sometimes be misused as a standalone indicator, it remains valuable as part of the trade valuation process.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.