The Skinny On Options Math

How is Probability of Profit Calculated?

| Apr 10, 2014
Up Next
    The Skinny On Options Math

    How is Probability of Profit Calculated?

    Apr 10, 2014

    A crucial metric here at tastylive, probability of profit (POP) gives us a gauge of potential success on different trades. We get a lot of questions about this, and so we wanted to clarify its calculations, both formally and ‘back of the envelope’ style.

    Jacob, a grad student at the University of Chicago and our resident mathematician joins the show to cover these formulas.

    First, he outlines some basics about calculating probability of profit. Jacob emphasizes that the formal calculation is dependent on the model that is used to assess the probabilities of the underlying’s movement. We must also understand where the break-evens are on a trade to calculate probability of profit, which can be calculated if we know the credit/debit earned on a trade.

    When formally calculating the POP, an assumption must be made about the distribution of the underlying’s movement. Options pricing models are used to accomplish this, with Black Scholes being perhaps the simplest and most widely used. This allows us to model the probabilities of an underlying getting to certain ranges.

    Jacob reviews the Black Scholes formula, pointing out where inputs like the strike price, credit received, risk free rate, time, and volatility come in. From this formula, the probability of profit can be derived. However, Jacob discusses some additional things to keep in mind when interpreting the final statistic, including the assumption that the trade will be held until expiration.

    To reach a calculation quicker, a ‘back of the envelope calculation’ may be more useful. Jacob provides a simplified rough calculation, which only requires the max profit and max loss as inputs.

    This calculation differs from the probability of expiring below a breakeven because it does not take into account that trades can be managed at less than max profit or loss. Finally, Jacob explains how the calculation’s accuracy is affected for narrower and wider defined risk spreads, and that it is minimally affected by directional or systemic bias.

    In summation, probability of profit calculations, whether they are done formally though the dough platform or informally on a napkin, can give us a better sense of possible success rates on a trade.

    This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.

    More like this

    tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, digital asset, other product, transaction, or investment strategy is suitable for any person. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastylive is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer.  Options, futures, and futures options are not suitable for all investors.  Prior to trading securities, options, futures, or futures options, please read the applicable risk disclosures, including, but not limited to, the Characteristics and Risks of Standardized Options Disclosure and the Futures and Exchange-Traded Options Risk Disclosure found on

    tastytrade, Inc. ("tastytrade”) is a registered broker-dealer and member of FINRA, NFA, and SIPC. tastytrade was previously known as tastyworks, Inc. (“tastyworks”). tastytrade offers self-directed brokerage accounts to its customers. tastytrade does not give financial or trading advice, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastytrade’s systems, services or products. tastytrade is a wholly-owned subsidiary of tastylive, Inc.

    tastytrade has entered into a Marketing Agreement with tastylive (“Marketing Agent”) whereby tastytrade pays compensation to Marketing Agent to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. tastytrade and Marketing Agent are separate entities with their own products and services. tastylive is the parent company of tastytrade.

    tastycrypto is provided solely by tasty Software Solutions, LLC. tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.

    © copyright 2013 - 2024 tastylive, Inc. All Rights Reserved.  Applicable portions of the Terms of Use on apply.  Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastylive’s podcasts as necessary to view for personal use. tastylive was previously known as tastytrade, Inc. tastylive is a trademark/servicemark owned by tastylive, Inc.