Want to Profit With Options? Use Three Probabilities
When surfing the web, it’s easy to find several different sites that will generate a very common probability found in the options world: Probability of profit.
Has a nice ring to it, right? The only problem is, the probability of profit doesn’t give you as much to work with as you think. At least when you use it as your sole calculation.
Simply put, the probability of profit measures the likelihood that your trade will become profitable. This is a literal measurement; it calculates the odds that a specific trade will yield at least one penny in profits, including commissions. However, that reading doesn’t do serious traders much good without other probabilities to compliment it.
It’s like having a computer without a keyboard or a house without doors. It may look nice and all, but how practical is it without other features?
That’s why at OptionParty we use three probabilities, one of which is the probability of profit that we just discussed. The others include probability of total loss and probability of target return. What are these?
The probability of total loss is exactly what it sounds like: The likelihood that the trade will result in the worst possible loss. While many traders use stop-loss orders to limit their losses, this probability’s responsibility is not to account for such potential orders. Its job is to calculate the worst-case scenario.
In order to calculate the probability of target return, traders first need to identify their return objective. Is it 2%? 8%? Somewhere in between perhaps? Either way, once the target return is entered, the probability or likelihood that that return will be reached can be calculated. It could be argued that this measurement is more beneficial to traders than the ever-so-common probability of profit.
So let’s take a look at some examples to see how this pans out. In our scenario, it’s late-August and we’re looking for a 6% return on our trade using an expiration of no more than 8 weeks.
|Left: A “Story Mode” snapshot of the results Option Party members will find when using the screening options to find the best trades.
Here we can see what calls to sell, which to buy and at what price. We can also see the probability of target return, probability of profit and probability of total loss.
How about this trade: Selling the October $49/$50 bear call spread on Halliburton (HAL) – a bearish strategy that traders enter when they believe the underlying security will trade flat to slightly lower by expiration.
The probability of profit shows an 85.9% chance that we’ll make a gain on our trade – and that includes commissions! So what’s to lose? We already know there’s a good chance of profit. After all, for every 100 trades we perform like this, a whopping 85 of them will result in a profit of a penny or more. Better than a loss, right?
This is exactly the problem with only using one probability, the most readily available one at that. The probability of profit simply leaves out too many other important considerations.
For example, in this trade there’s a 10.3% chance of experiencing a total loss. 10.3%! While there is an 85.6% chance we’ll hit our target return of 6%, the more than one-in-ten deadly odds that we’ll experience our max pain – in this case a HAL close above $50 – should be enough to turn off many traders.
Now let’s look at a trade with the same 6% return, but with a lower risk profile. Remember, it’s late-August in our example.
|Right: Now in “Data Mode” we can see that although the probability of profit is lower than in the first trade, the total loss probability is greatly reduced, making this a better overall trade.
The “Quantity” column in the bottom box can be adjusted by Option Party members, as they can alter the dollar amount for each trade.
Here’s a better one: Sell the October $82.50/$77.50 bull put spread on Exxon Mobil (XOM). That means we are neutral to bullish on Exxon, at least to the point where we don’t think the stock will advance that much over the next six weeks.
There’s an 82.7% chance that we’ll hit our target return of 6% and an 84.4% chance we’ll generate a profit of a penny or more. However, instead of finding a trade with a remarkably high total-loss probability, this trade has just a 2.9% chance of experiencing a total loss.
Even though our probability of profit is lower than in the first trade, we still have a very good chance of hitting our target return and doing so with a lot less risk. These are the types of trades that traders prefer to enter and that’s exactly why using three probabilities rather than one is the smart and rational choice.
In both examples, each trade has a more than 80% likelihood of generating a profit. But without other key inputs – such as profit target, probability of profit target and total loss probability – we could have taken on a trade that had a much higher risk than the other. Another problem? The increased risk didn’t even result in an increased reward.
And that’s the whole goal in trading: finding a balance between maximum reward and minimal risk. Using probabilities will greatly help in that endeavor.