Probability of profit (POP) refers to the chance of making at least 1 INR on a trade.
This is an interesting metric that is affected by a few different aspects of trading – whether we’re buying options, selling options, or if we’re reducing cost basis of stock we are long or short.
When we sell options, we sell them at strikes that are at the money (where the stock price is trading) or out of the money (at a better price than where the stock price is trading). Knowing this, we can automatically assume that we will have a greater than 50% probability of success if we believe just buying or selling stock outright will yield a coin flip opportunity.
The CMP of Hindustan Zinc is 280.7.
The CMP of Hindustan Zinc July Futures is 281.35. We shall discuss pricing of futures later but at the time of expiry CMP of Hindustan Zinc July Futures which is at 281.35 – 280.7 = 0.65 INR premium now will coincide with Hindustan Zinc share price.
POP of shorting Hindustan Zinc 280CE > POP of shorting Hindustan Zinc July Futures > POP of shorting Hindustan Zinc Shares
When I short option at 280 with price 5, I’ve already got premium (forgetting the blocked margin for now), now on expiry, I’m obliged to sell the shares at spot price, but given that he’s already paid a premium of 5rs, the spot price has to be above 280+5 = 285 for the buyer to be in profit, conversely, it has to be below 285 for us to be in profit. So a window of 5 rs in OPT
When I short futures at 281.35, and it expires, I’m obliged to sell the shares at CMP (which will be equal to fut price then), now buyer has already settled for 281.35 which should be broken by CMP for him to be in profit, conversely, CMP should be below it for us to be in profit. Thus a window of 0.65 in Futures.
Equity is simple, the price has to actually close below CMP. a window of 0 for equities.
In short, even if the price moves against our bet, we’ll be in profit in case of opt (and to some extent in future). Thus this difference of 5 > 0.65 > 0 means higher POP for opportunities.
What if we buy 1 lot of Hindustan Zinc futures and sell Hindustan Zinc 280CE. What is our breakeven point? Do we have an unlimited downside or do we have a limited upside?
We also have more ways to be successful with strategies like this. When selling an option, the stock price can stay the same, go in our favor, or go against us just a bit and we’ll still be profitable at expiration. The ability to make money in multiple ways results in a higher probability of success overall.
When selling options, we collect a credit, which is premium. This credit can be used as a buffer against losses on our position, which grants us an even higher probability of success. Because our breakeven price is directly related to our POP, and this breakeven is improved by selling premium, we can consistently improve our POP with premium-selling strategies.
In Option selling we need to lose the premium first to make a loss; In Option buying, we need to earn the premium first to make a profit.
When we buy options, we are usually referring to buying spreads. Buying a naked option is the worse thing we can do for our break-even, as we don’t hedge the cost of the option in any way. (which means hedge to make a sure shot profit to gain back our premium)
This is why we stick to spreads. Our goal when buying spreads is to obtain a breakeven price that is very close to where the stock price is trading now or just a bit better in an ideal setup. Doing so ensures that we have around 50% POP or just a bit better.