where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
This edition of Profit talk we’ll cover using option delta to determine the statistical probability for profit in a stock or option investment. Also, we’ll take a look at the relationships that exist between the probability of profit or “POP” for short, return on capital , referred to as “ROC” and the risk to reward ratio.
These “three amigos” are interrelated and are the key components considered when placing trades or entering investments of any kind.
Probability of Profit “POP”
As options traders we have access to tools with extraordinary power when it comes the art of prognosticating. Prognosticating is the act of foretelling or prophesying future events. When it comes to accurately predicting the future outcome of an asset’s price, the option pricing models have been tested and proven over time to have astounding accuracy.
The (absolute value of) Delta is close to, but not identical with, the percent moneyness of an option, i.e., the implied probability that the option will expire in-the-money . For this reason option traders use the absolute value of delta as an approximation for percent of moneyness. For example, if an out-of-the-money call option has a delta of 0.15, the trader might estimate that the option has approximately a 15% chance of expiring in-the-money, which means above that short call strike price. Similarly, if an OTM put contract has a delta of −0.25, the trader might expect the option to have a 25% probability of expiring in-the-money, meaning below the Put strike price.
This information is easily accessible on the option chain. Depending how your option chain preferences are set-up, the probability of profit value may or may not be displayed. The POP value is drawn from the delta value. As explained, the delta value is the probability the option will expire ITM, which is above the strike for a Call or below the strike for a Put. For an option seller, the probability of profit or POP is the inverse of the delta value. This is because delta is the probability for that strike being ITM at the time of expiration. Option sellers want the option to expire out of the money making them worthless. This makes the options seller’s POP the inverse of delta.
Looking at the option chain you see the delta for strikes at the money are generally around .50. In this case there is about a 50% chance the price will below the nearest OTM Put strike or above the nearest OTM Call strike. Again, the POP for an option seller is the inverse of the delta value. In this market you see that the OTM 233 Put strike has a probability of being out of the money on expiration of almost 53% . (Figure 1) This makes the POP or probability of profit around 53% for the seller of this Put option. The further out of the money you go the lower the chance of price being in the money, the delta value is lower which makes the inverse, the POP, higher. It makes sense, because the further you are from price, the less chance of price getting there.
On the other hand, going in the money increases the chance of being ITM at expiration and therefore increases the delta value. This lowers the POP for options sellers and raises it for the option buyer. This is the reason why we almost always sell OTM options and buy ITM options.
Also, the time frame will affect the delta value. The shorter time that price has to move the lower chance of it reaching a particular strike. The more time or further out the expiration, the more chance it has of reaching that strike price. This and the proximity of current price affects the delta value of the option.
The proximity to current price and days to expiration not only affect the probability of profit but they affect the size of the profit as well. This is because the credit received varies based on the probability price has of expiring in the money. The probability of profit and the credit received have an inverse relationship. This makes sense, because the lower the chance an option has of being in the money on expiration means the less option buyers are willing to pay for the option. This lowers the credit. The seller has a higher chance of profiting but receives a lower reward.
This fact points out a key relationship we’ll look at next between the probability of profit and return on capital.
Return On Capital
Typically speaking the return on capital or ROC for short will have an inverse relationship to the probability of profit or POP. This leads to the analysis every trader must consider when considering a trade or investment. There is always the trade of ROC versus POP.
As an option seller moves the short option strike price closer to the money they increase the credit and therefore the return of the investment. More than just the straight return is affected. The return on capital is also influenced. The capital used to sell a further out of the money option compared to a closer to the money option is slightly less but not nearly enough so, as to overcome the deficit to ROC created by the diminished credit received. The return on capital is lower the further out of the money you go when selling options.
Look at the SPY option chain for example. You can see that selling 1 OTM Put just slightly below current price takes about $4800 in capital and brings in $308. This is a return on capital of about 6.5% and carries about a 55% probability for profit. If you go further out of the money, say down to the 225 strike, the capital requirement drops down to about $4100 and the credit received is $172. The return on capital drops down to about 4.2% and the probability for profit increases to about 74%.
The ROC vs. POP trade off is one that should be considered when comparing prospective trades. Additionally, the important consideration of ROC & POP has a direct influence on one of the most important metrics in all of trading, the reward to risk ratio. The manner in which the trade is constructed will greatly influence the amount of risk in the trade as well. This measure also has an interesting dynamic involved when considering strike selection. The probability for profit and reward to risk ratio have an inverse relationship or are typically negatively correlated to each other just like ROC. This because the closer the short strike is to the current price the higher the credit or reward but of course the lower the chance for actually receiving the reward.
This fact makes for an interesting conversation between traders or for traders to have with themselves in regards to strike selection. Is it better to take a smaller reward which has a higher probability for success but a worst reward to risk ratio, or take a larger reward, creating a better reward to risk ratio but a lower chance for success?
The real answer to that question depends on a few factors, not least of which is the trader's personal preference and risk tolerance. The better chance a trader has of controlling and limiting the risk, the more acceptable it is to take a trade with an initially poor reward to risk ratio.
For example, if a trade is being considered for an earning release, a closer to the money strike will bring in more credit which is positive for the reward to risk ratio and return on capital metric, but the increased chance of a significant move against the position with the greatly diminished chance for defending the loss stemming from a significant move while the market is closed, may favor a lower ROC and reward to risk ratio for receiving a higher chance for achieving at least some profit.
Again, this is a key argument traders must make with themselves every time they are considering an option trade. There is no “off the shelf” right answer to that question in most cases. It is a question of personal taste and style of trading. But, it’s important to understand the relationships and have the ability to analyze what it means for you when considering a trade.
In the end, a nice balance between probability of profit and the risks involved will help to maintain a long and profitable trading journey.
The top takeaways this week are:
First, an option trade’s POP or probability of profit is inverse to it’s proximity to the current stock price. The further the strike is from current price the higher the chance of profit.
Second, a trade’s ROC or return on capital diminishes as the distance from current stock price increases. This means ROC & POP have an inverse relationship to each other.
Third, the reward to risk ratio is negatively affected by moving strikes further out. The balance between probability of profit and the reward to risk ratio must always be considered and managed to fit the personality and risk tolerance of the trader.
This relationship between probability of profit, return on capital and the reward to risk ratio associated with the trade is considered the main factor determining the viability of almost any investment.
This past week we have seen some follow up to the recent weakness in the markets. As I mentioned last week, we’ve seen the VIX or fear index hold on to its recent gains. This is quite different from what has been experienced over the last 5 or 6 months.
Also, another shift I see in the recent markets is less of a tendency to buy the dips. Rallies have been met with selling which is a stark change from what has been the norm in recent months. Does this means a correction or sell off is imminent? Not necessarily, but based on current market valuations, the risk to the downside is higher than the risk to the upside.
In addition, the broad US markets have dropped below the medium term trend average but remain above the larger time frame average. And, geopolitical events are causing some fear to creep into the markets. As traders, this can be a good thing as it brings volatility and more opportunity for a two-sided “traders market”.
The high impact reports due out this week include:
Tuesday 4/18 - Building Permit numbers are being released at 8:30 am eastern
Wednesday 4/19 - Crude Oil Inventories will be released at 10:30 am eastern
Thursday 4/20 - Unemployment claims and the Philly Fed Manufacturing Index numbers will be released at 8:30 am . Plus treasury secretary Mnuchin Speaks at 1:15 pm
As always these reports and speeches have the ability to move markets and create opportunity for the trader who is prepared.
Remember, success comes when opportunity meets preparedness.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at firstname.lastname@example.org.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.