Probability of Profit (POP) is the probability that your option will make you money. In our case, we typically either make 100% profit or 200% loss. You rarely have any other outcome with this system. So since we have an 85% chance of a winning trade, we are in a highly powerful position. With TastyTrade you look for the 1SD trade around -0.15 Delta and with Robinhood you can easily see the POP (what they call “Chance of profit”). With Fidelity, you can see the Delta (-.15) which is roughly the chance of the option winning (including the premium received). In options trading there are some basic concepts that you need to understand. There is extrinsic and intrinsic value in every option. Intrinsic value is the difference between an option’s strike price and the underlying asset’s price. Extrinsic value is the difference between the market price of an option and its intrinsic value.
Moneyness is another important concept. When an option is “In the Money” that means that it has intrinsic value. For example, if you hold a call option for TSLA at $100 and the stock price is currently at $109, then you would have $9 of intrinsic value. Another way to look at it would be, if you exercised the option you would own the stock at $100, then you could sell the underlying stock for $109, making $9 profit per share (or a total of $900). Before you exercised it, the call option would also consist of extrinsic value. The extrinsic value largely depends on the time to maturity and the volatility of the asset. Time to maturity is defined as the time left in days until the option contract expires. The volatility of the asset is really a market perception and is the largest variable in the Black-Scholes model. It is typically the variable that you solve for in the Black-Scholes equation as all other values are known. Another moneyness category is “At the Money”, which means the spot price (current stock price) is equal (or nearly equal) to the strike price. The strike price is the price on the specific option contract that you are entering into. Also, an option can be “Out of the Money”. Out of the Money means that there is no intrinsic value. All of the options that we trade are Out of the Money. We trade options that are fairly far out of the money, and we want them to stay that way. We are opening positions on Put options that have an 85% probability of profit (around -.15 delta), which basically means that there is an 85% probability that the underlying price does not close below our strike price (plus the premium credit received). For example, when we sell a Put option at a strike price of $90 on an underlying that is currently valued at $100, we are betting that the stock will not close below $90 (less the premium credit received) at expiration. So, if we received a $0.50 credit when we opened, we are profitable if the stock closes above $89.50 at expiration.
I have a statistics background, which comes in very handy when trading options. All of this is math and probability based. It’s risk versus reward. Options are priced using expected outcomes on the Normal Curve, and every outcome (stock price) has a corresponding probability of occurrence along the curve. So how did 85% become the optimal range? I was trading overly conservative (after I lost a lot of money initially) for a while using a 95% POP. For reference, 95% POP is roughly 2 Standard Deviations (STDDEV) on the Normal Curve of the expected outcomes, which basically means I had a 95% chance of being profitable on the trade. The problem was that I wasn’t making enough money on those trades. I was getting about 75% less premium (credit) that I’m collecting now. Sure, your winning percentage is higher, but overall profitability is lower. So, over the years I tweaked the system, and tweaked, and tweaked….and tweaked. Using my projected profit model based on POP and options premium, 85% was calculated to be the sweet spot, and 85% is roughly 1 Standard Deviation to the downside. Simply stated, any more than 85% POP and you don’t make enough money on each trade, and any less is riskier and your profitability starts to decline in aggregate. In more advanced posts, I will dig into the details of my profitability model and the Black-Scholes model and how this affects pricing / options premium, but for now we are ready for the next step along the Put Path!
Put Paradise 