What is the Probability of Profit
When a probability trader is to set up a trade, he will sell an option to receive premium. Of course he enters the trade with the highest POP in order to make a good profit.
Probability of profit (POP) refers to the probability that we will make at least $0.01 on any given trade. For example, if we sold a 100 strike call in XYZ stock for $1.00, our POP is the probability that XYZ will expire at 100.99, or below (1 penny profit). So, if the 100 strike had a probability of expiring OTM of 84%, our POP would be greater than 84% because POP includes any credits we receive in our trades.
When we are short options, we want them to expire worthless or out of the money (OTM). When we are long options, we want them to expire in the money (ITM). At selloptionpremium we generally only sell option premium using OTM options. For example, if our short strike is 1 standard deviation away from the underlying’s price, this computes to a probability of being OTM at 84%, or a probability of being ITM at 16%. While we will look at the probabilities of an option expiring OTM or ITM when selecting strikes, the trade’s overall probability of profit is what we will weigh more heavily when considering trading strategies.
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The price of an equity can be under or above the strike price of an option. Most of the prices are in the neighbourhood of the strike price but some are further away. This is graphical represented by the bell curve.
The Bell curve explains the normal distribution of random outcomes of asset prices. In other words, we are statistically determining the probability that the price of an asset will fall within a range over a specified period of time and current level of volatility.
This relies on the fact that you cannot predict how much the price will move of a stock and in which direction it will be. It is predominantly random. Much research has been done in this area, and it has been shown that the price action of stocks are random.
There are three key inputs to the Probability Model that probability traders focus on: price of the asset, implied volatility and days to expiration of the option. It then becomes a simple matter to determine the range of prices and the POP based on the expected move for a given level of risk.
Delta is used as the probability that an option will wind up at least $.01 in-the-money at expiration. Technically, this is not a valid definition because the actual math behind delta is not an advanced probability calculation. However, delta is frequently used synonymously with probability in the options world.
One interpretation of Delta used by traders is to read the value as a probability number – the chance of the option expiring in-the-money. For instance, the at-the-money 110 call with a Delta of 0.52 in this case suggests that the 110 call has a 52 % probability of expiring in-the-money. Of course, underlying this interpretation is the assumption that prices follow a log-normal distribution (essentially daily price changes are merely a coin flip – heads up or tails down).
Conclusion of Probability of Profit
We Sell Options in order to receive Option Premium. We use Delta to determine how likely it is to get a small or a bigger profit. A higher number means that you have more possibility of profit.
Because we sell options in order to receive option premium with delta we can easily determine the risk we take and the how much chance we’ve got to keep the premium.
When you select an option on the ThinkorSwim platform you can easily see what the delta of an option is and how likely it is to end up in the money. Usually the probability of profit percentage is over stated.