Probability of Profit (POP)
Understanding Probability of Profit (POP) in Options Trading
What is Probability of Profit?
Probability of profit in options trading represents the statistical likelihood that an options position will be profitable at expiration. This metric is calculated using the current stock price, strike prices, implied volatility, and time until expiration.
Key Components Affecting POP
1. Implied Volatility (IV)
- Higher IV increases the expected range of possible prices at expiration
- Affects option premium and therefore break-even points
- Based on market's expectation of future price movement
2. Time to Expiration
- Longer expiration periods typically have lower POP but higher potential profits
- Theta decay accelerates as expiration approaches
- Time decay works in favor of option sellers
3. Strike Price Selection
- Distance from current price affects POP
- Further OTM options have higher POP but lower potential profits
- ATM options typically have around 50% POP
Common POP Values for Option Strategies
1. **Short Put Vertical Spread (Bull Put Spread)**
- 30 delta short strike ≈ 70% POP
- 16 delta short strike ≈ 84% POP
- Maximum profit is limited to credit received
2. **Short Call Vertical Spread (Bear Call Spread)**
- 30 delta short strike ≈ 70% POP
- 16 delta short strike ≈ 84% POP
- Maximum profit is limited to credit received
3. **Iron Condor**
- 1 standard deviation (16 delta) ≈ 68% POP
- 2 standard deviations (5 delta) ≈ 95% POP
- Profitability range is between short strikes
4. **Short Strangle**
- 16 delta strikes ≈ 68% POP
- Higher risk due to unlimited loss potential
- Wider break-even points than Iron Condor
Practical Example
Let's analyze a bull put spread on a stock trading at $100:
- Short 95 put (30 delta) = $1.50 credit
- Long 90 put (15 delta) = $0.50 debit
- Net credit = $1.00
POP Analysis:
- 70% probability of stock staying above $95
- Break-even at $94 (short strike - net credit)
- Maximum profit: $1.00 (net credit)
- Maximum loss: $4.00 (strike width - net credit)
Risk/Reward Considerations
1. **Higher POP Trades**
- Lower potential profit
- More consistent wins
- Requires larger position sizes for meaningful returns
- Example: 85% POP might yield 15-20% return on risk
2. **Lower POP Trades**
- Higher potential profit
- Less frequent wins
- Smaller position sizes needed
- Example: 40% POP might yield 150-200% return on risk
Common POP-Based Trading Rules
1. Enter trades with 65-75% POP for balanced risk/reward
2. Adjust positions at 2x initial credit received
3. Take profits at 50-75% of maximum potential profit
4. Consider rolling positions when POP drops below 30%
Limitations of POP
1. Based on log-normal distribution assumptions
2. Doesn't account for black swan events
3. Historical volatility may differ from implied volatility
4. Market conditions can change rapidly
Best Practices
1. Combine POP with other technical indicators
2. Consider implied volatility rank/percentile
3. Monitor position delta for directional risk
4. Use appropriate position sizing
5. Have a clear exit strategy before entry