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.
When we sell options, we sell them at strikes that are at the money (where the stock price is trading) or out of the money (at a better price than where the stock price is trading). Knowing this, we can automatically assume that we will have a greater than 50% probability of success if we believe just buying or selling stock outright will yield a coin flip opportunity. We also have more ways to be successful with strategies like this. When selling an option, the stock price can stay the same, go in our favor, or go against us just a bit and we’ll still be profitable at expiration. The ability to make money in multiple ways results in a higher probability of success overall.
When selling options, we collect a credit, which is cash. This credit can be used as a buffer against losses on our position, which grants us an even higher probability of success. Because our breakeven price is directly related to our POP, and this breakeven is improved by selling premium, we can consistently improve our POP with premium selling strategies.
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.
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.
Market Data provided by CME Group & powered by dxFeed Technology. Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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