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Speaker: Okay. So let�s talk about Probability of Profit. I�m going to call this PoP short.
Basically whenever we do a trade, we can do a calculation and figure out what exactly
is the probability of profit of this trade. So this is very beneficial for your trading
plan or for your any perspective trade that you�re looking at. You can say you know
what, I�m going to put on trades that have a 60% probability of profit and I�m looking
for this much return or a 70% probability of profit or a 20% or a 90%. And normally
to buy a stock you have a 50-50% chance of it going up and a 50-50% chance of it going
down, same thing with � if you buy at a call option or a put option. But in our particular
trades, actually you can do the same thing if you just buy the call or buy a put. You
can actually figure out what percentage or what likelihood that trade is going to make
money. So that�s what we�re going to talk about in this video.
And each option trade like I said before has a probability of profit and that probability
of profit can actually help you determine if you want to make the trade or not. So if
you are a very conservative option trader, option seller and you only want to deal with
trades that have a 90% probability of profit, then you can do so. If you�re more aggressive
and you like say butterflies, then you can choose a 40% or a 50% probability of profit.
It all depends on the strategy. It all depends on your particular risk tolerance.
Now the probability of profit should be part of your trading plan. So if you�re doing
a certain type of strategy, it should be part of your plan that I�m only going to do trades
with an x-percent [00:02:00] probability of profit or higher. So an example of that would
be, I�m only going to do credit spreads and I�m only going to do them with 30 days
to expiration or less and I�m going to look for 80% � 84% probability of profit or more.
So if they�re 32 days out, no, I�m not going to do them. I�m going to wait two
more days until it�s 30 to expiration and if it�s giving me a 60% probability of profit,
I�m not going to take the trade even if it was going to give me 90% return on my money.
If I want it, I�m only going to do 84% or more. So I could a 90% probability of profit,
but my main aim is 84% profit, that�s one example of a trading plan that you have to
setup.
Now, the PoP is going to help you determine if your trade is too risky as well. So if
you�re doing credit spread or if you�re doing an iron condor and you have a 20% probability
of profit, then you�re most likely you�re too close to the money. You�re very close
to the money and you�re probably going to lose on that trade. It could also help you
determine if you�ve done the trading correctly. So if you�re putting in a trade and you
should be getting 60%, 70%, 80% probability of profit, but then suddenly you have a 40%
probability of profit, then you probably did something wrong. So it�s another check just
to make sure that you�re entering the trade correctly.
And the big thing about probability of profit is going to help you pick your strikes especially
in credit spreads. So a lot of times you�ll � in order to � you�ll find the trade,
you�ll find the stock, you�ll find and say okay, you know what, based on my technical
analysis or based on anything else that you want to look at, this trade is � this stock�s
trading in a range and it�s not going to go below for example let�s say 50%. It�s
not going to go below 50% and I want to trade it this month or 30 days left expiration,
what strike can I use. I would like to find the � I would like to say go and say you
know what; I want to find a strike that�s far below 50%. I didn�t mean that I don�t
think it�s going to go below 50%. I want to find a [00:04:00] strike that is as low
as I can go below 50% and still get a decent premium, but just in case the 50% is broken,
the 50% trend line is broken.
So you go and you can look at the option chain and you can actually see okay fine, at 50%
I�m getting � I have a 70% probability of profit at 50% -- at 45%, I�m getting
a higher probability of profit and then you look at that and compare the premium that
you�re getting and the return that you�re getting in order to determine if you want
to go at the 50% or the 45% or the 40% or the 35% or any other strike.
Now, how is this determined? How this PoP determined? Well actually it�s a very sophisticated
mathematical calculation. We use statistics to determine what it is and there are many
different things that you go into the formula, volatility of the stock, days to expiration.
Those are just two of the items, also the type of option, pricing model that you�re
using. There are different ways to value what an option is worth; [indiscernible] [00:05:19]
is one of the most popular ones. If you�re use [indiscernible] [00:05:23] your PoP will
show up as one percentage, if you use a different pricing model, it might vary depending on
what the prices of the options and what not. It is a very complicated formula and something
that we are actually not going to get into here, but you can look it up online and see
what the formula is.
I will show you two ways that you can do without the formula, because I don�t use the formula.
I never have, I never need to. But the one thing I want you to remember is that PoP is,
it�s a tool, but it�s not guaranteed. I mean it�s wonderful; it�s great to say
that hey you know I�m doing trades with only [00:06:00] 90% probability of profit.
I mean I�m going to win 90% of the time. I wish that were true. But it doesn�t always
work that way just because it�s � when you have a really high probability of profit,
you can still lose money. There is still that 10% of chance of you losing money and if something
is � if the variables that you put into the calculation are garbage then your result,
your probability of profit that you came up with is going to be garbage, so if you have
� if the volatility of the stock all of a sudden changes then your PoP is going to
be wrong. So you have to remember that things need to stay constant while you�re in the
trade, if they�re not constant then your PoP is going to change and the whole trade
is going to be off.
And most PoP calculations are based on a 68% certainty. So if you know anything about statistics,
you know that � if you go out one standard deviation, you have a 68% -- you can speak
with a 68% certainty, two standard deviations is I believe � I don�t remember, I think
it�s 92% certainty and then three standard deviation is 98% or they�re different basis
of certainty that you can say. So any PoP, most of the calculations that people say that
this trade is going to come, it�s going to give you a 90% probability of profit or
yeah it�s a 90% probability of profit, but it�s only a 68% chance of that profit potential
coming through. So, it�s a good way, it�s a good tool, but I think with a great assault.
So now I said there is a way to calculate the PoP mathematically. We�re not going
through that here as it�s going to be too complicated and plus I�m not good at math.
So I�m going to go over the two simple ways that work well enough. The first off is by
using delta. Delta is an option Greek and we�re going to cover that in one second.
And then second way is by using your broker�s software [00:08:00]. Most of the brokers nowadays
are very good, very technically advanced free software that you can use and by using their
charting system you can pretty much pretty accurately tell what the PoP of a trade is
going to be. So we�ll go over an example of that.
Now, to use delta to find the PoP, now here is an example of a credit spread. The delta
of the short strike tells you the probability of that option expiring in the money. Again,
the delta of the short strike, you don�t need to look at the � in a credit spread
you don�t need to look at the long strike, you just look at the short strike, the one
that you�re selling, take a look at the delta, the delta of that option. And if you
don�t see the delta on your option chain, there will be a way that you can manipulate
the screen so that it will show you the delta and the delta is going to be given to you
in a decimal. So .15, .20, .90, that is the delta of the trade. It could also be negative,
so a negative .15 if you�re working with other options.
So, look at the delta and that delta will tell you the percentage chance of that stock
or that option being in the money, expiring in the money. Now we don�t want in the money,
we want out of the money, right. We wanted to be expiring worthless. But if you have
a call and say it has a .15 delta that means that that particular call has a 15% chance
of expiring in the money. Now if we�re going to buy that call that�s � it�s not a
good bid, because you only have 15% chance of winning. But if you sell the call, you
have an 85% chance of making money because you have an 85% chance of that particular
call expiring worthless. So if we did a credit spread and the short call was a .15 delta
that means [00:10:00] that our trade has an 85% chance of making money that will be our
PoP for that particular trade.
Now, again with credit spreads we�re only concerned with the short option expiring worthless,
because the � if the short option expires worthless obviously the long option has been
always part of worthless. So we�re only looking for that particular delta when you
try to figure out the PoP, okay.
Now let�s go ahead and take a look at how you will find the PoP using your broker software
and in this particular instance I�m going to be using the thinkorswim platform. Other
brokers have their own different softwares. So here we are in the thinkorswim trading
platform owned by TD Ameritrade and any broker that you use will probably have something
similar to this. You can ask them how to do this on your particular platform if it�s
much different from here. But I just go ahead and use this as an example to show you how
to choose and how to determine the probability of profit on the credit spreads.
Let�s go ahead and do it by the delta way and then we�ll also do it by the chart way
and compare the two. There should be a little bit of difference, because the delta way that
I showed you is � it�s a rough estimate, it�s not exact and then the chart way will
be a more scientific number, it will be a more exact number. So right now what we�re
looking at here is this is IBM, as you can see IBM and this is an option chain of IBM
and the ideas of the different months. There is December up weekly, December which has
11 days to expiration and January which has 46 days to expiration. These are the calls
on this side. These are the puts on this side. These are the strikes going down. As you can
see the different columns, you have bid, ask, mark and then change. What we really want
is to look at the delta. So I like to change one of these columns here [00:12:00]. Let�s
go ahead and change mark, delta probably in here, yeah there we go. There is the delta
and you will notice that puts have a negative delta and calls will have a positive delta.
So let�s go ahead and look at some calls. And right now there is 46 days to expiration,
IBM is trading at 190.84. Now, if you look at the 195, look at the 195 strike call which
is about $4 away out of the money. This software is telling us that this call has a delta of
.4 and in other words that is telling us that this particular option has a 40% chance of
expiring in the money. Conversely it has a 60% chance of expiring out of the money. So
that 200 has a 20% chance of expiring in the money, the 205 has a 17% chance of expiring
in the money and the 210 has a 9% chance of expiring in the money. So if we had bought
the 210 according to the math here, you have a 9% chance of it getting somewhere above
210. It doesn�t mean you�re going to make money, because you still have to pay for the
option, but the 9% chance of IBM getting to 210.
So even if you�re looking to buy a stock, if you�re looking to buy a stock and you�re
looking what is the chance of the stock moving up, chance of going down, what are the market
makers thinking. Well they come here and look at the option change, look at the deltas of
the options and you can figure out what the market is thinking in terms of this stock
is going up or down. So for example [00:14:00] if you look at the 195 strike again, there
is a 40% chance of this being in the money. But at the same time there is a 61% chance
of this being � the put being in the money. So that works up to a 101% chance. The market
is � so that�s not right, but if you look at it this way, the market, right now the
market makers are bearish on IBM. So they do not think that IBM will be above 195 within
the next � with on expiration date of 45 days from now, 46 days from now. So that gives
you a little indication of what the market is thinking, what the market makers were thinking.
Now normally the puts will have a higher premium, so that kind of makes an effect as well, but
it just gives you a guideline.
So now let�s say we do � we want to do a credit spread and like I said in the credit
spreads, you want to look at the actual short strike. So if you want to sell the credit
spread and if our range is � if our trading plan says we want to do it with at least a
90% probability of making money, then the only one we could be doing is probably the
210, because that one is 91% probability of profit, but they also do these other here,
but they probably won�t give us enough money. So this one right here is the only one that
fits into our PoP criteria of being 90% or greater, okay. So that is the delta model.
That is how you figure out very quickly, very easily, it�s not exact, it�s not an exact
science, it�s a rule of thumb type thing. If you�re doing your trade and you�re
looking at it and you say okay, I�ll � looking at this one, okay, it�s got a � it�s
lower than a 10 delta [00:16:00], I like it, boom, I�ll do it, okay.
Now let�s go ahead and do the chart method. So what I want to do is go ahead and put � pick
a spread, let me move just down a little bit. We�ll go ahead and pick the same 210 and
we�ll compare the two. So sell vertical. So now according to this, what we�re doing
here, this is the trade that I�m considering. It says sell 10 IBM, January 210 calls, buy
10 January 215 call. So this is a five points credit spread and you see there is our potential
credit, that�s what we could be getting.
Now let�s go ahead and look at a chart and see what probabilities that the chart is telling
us, okay. We�ll get up a little bit more, there you go. Okay, so we�re going to set
the slices to the breakeven, there we go. We have to make sure that our probability
date is set on expiration day which is January 20 and according to thinkorswim, the probability
of profit for this trade is 86.7%. It�s a little bit lower than the 91% that we came
up with our delta model, because there are other factors included in this calculation.
So it�s about the same, but it�s a little bit, tad a bit lower. So if you want to be
stick to the rules and you want to be exact, then you probably have to use a calculation
from the chart, from the software. Otherwise you might just use the delta to be quick.
So now basically what this chart is saying here is that there is a 86.7% chance that
IBM, the stock of IBM is going to be trading in this range, anywhere between � anywhere
above 210.27, because this is our breakeven line right here. It�s not exactly 210; it�s
a 210.27, that�s our breakeven. So there is a 86.7% [00:18:00] chance that IBM will
be above this slide. It could be � it�s going to be trading below this line, because
here the prices are going down. So it�s going to be anywhere below 210.27 and there
is a 13.3% chance that IBM will be trading on expiration date above 210.27 in this range,
anywhere above here.
So, according to our trade, as long as it�s in this range we make money, if it�s above
this line, we lose money. So, we have a 86.7% chance of this particular credit spread making
money. Now this is what our � now, this is what this is actually telling us.
Now, there are different ways to change the parameters of this trade. For example, according
to this, IBM has a yield of 1.57 which is dividend. If you increase the dividend, if
you change the dividend, the probability of profit will change. If you change the volatility
then the probability of profit will be also same. So if you see here, as volatility goes
up your probability of profit is going down. So watch this number as I increase the volatility.
See how it�s going down as volatility goes up and then what if we decrease the yield.
If we decrease the dividend, then probability of profit also goes down. If you increase
the dividend, the probability of profit goes up. So there are � these are two other things
that are included including days to expiration. So if you want to change the date of expiration,
let�s just make it here, January of 2nd, see our probably of profit just jumped up
to 90%. But that�s not our expiration date. So we�re looking at 84.99%. Let�s go ahead
and put this back to where they were [00:20:00], okay and that�s exactly where we are now,
86.7%.
So this is how you calculate probability of profit using the chart. We also looked at
the delta model for a quick rule of thumb. And if � most of the time this holds out
and it holds out, it�s not exactly the most � it�s not guaranteed, it�s not setting
the stone and it works for credit spreads. It gives us a good indication. So if you�re
looking at different trades and you�re saying you know what, I might do the 200. Okay, I
will � just looking at the delta here it�s telling us that if we�re looking at a 80%
or 90% probability of profit trade, then this is going to be too high. If we�re looking
at this one, let�s say we want to do an 80% � 75% to 80% probability of trade, then
we can go ahead and take a look at this one, do the math and look at the chart and say
you know what, the chart on this one, let me go ahead and fix it, okay, all right. So
this chart, our breakeven actually gives us an 80.81% probability of profit. So that fits
between our rule of 80% or higher, so I like this trade and I get more money for it, I
get a $0.63 credit versus a $0.29 credit that we got for the other spread, that was five
points away.
So you can take a look at different trades based on the probability of profit. So that
is the PoP, that�s what it is, that�s how we use it and how we calculate it, all
right. Thank you, on to the next one.