The Unlucky Investor's Guide to Options Trading guides readers through the world of options and teaches the crucial risk management techniques for sustainable investing.
What is Probability of Profit (POP)?
Probability of profit (POP) refers to the chance of making at least $0.01 on a trade. This is an interesting metric that is affected by a few different aspects of trading - whether we’re buying options, selling options, or if we’re reducing cost basis of stock we are long or short.
Probability of Profit when Selling Options
Probability of Profit When Buying Options
When we buy options, we are usually referring to buying spreads. Buying a naked option is the worse thing we can do for our breakeven, as we don’t hedge the cost of the option in any way. This is why we stick to spreads. Our goal when buying spreads is to obtain a breakeven price that is very close to where the stock price is trading now, or just a bit better in an ideal setup. Doing so ensures that we have around a 50% POP or just a bit better.
Probability of Profit & Cost Basis Reduction
One of the coolest things about owning shares of stock is that we can accompany the trade with a free short call. This puts cash (not profit) in our pocket immediately, and doesn’t require any additional buying power. Selling one call against every 100 shares of stock we own allows us to collect premium and use that to reduce the cost basis of our shares. This turns a 50/50 coin flip in buying stock into a much higher probability of success. In selling the call, now the stock can stay exactly, move up, or move down a little bit and we can still profit by the amount of credit we receive. We never know where a stock may go, which is why we focus on improving what we can control: cost basis.
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