Why High Probability Trades Still Lose

Key Concepts

Probability of Profit (POP): The likelihood of a trade making at least one penny at expiration.
Return on Capital (ROC): The potential profit or loss relative to the capital required to hold a trade.
Defined Risk Trades: Trades with a predetermined maximum profit and loss (e.g., put credit spreads).
Undefined Risk Trades: Trades with potentially unlimited losses (e.g., short puts, strangles).
Buying Power Requirement: The capital set aside by a broker to cover potential losses on a trade.
Delta: A measure of an option's price sensitivity to a $1 change in the underlying asset's price.
Implied Volatility (IV): The market's expectation of future price fluctuations of an underlying asset.
Out-of-the-Money (OTM) Options: Options whose strike price is not currently favorable (e.g., a put option with a strike price below the current market price).
At-the-Money (ATM) Options: Options whose strike price is close to the current market price.
Short Premium Trades: Trades where the trader sells options, collecting a premium upfront.
Probability of Touch: The likelihood of an option's strike price being tested during the life of the trade.
Win Streaks: Consecutive profitable trades.

Illusions of Safety: Probability of Profit vs. Return on Capital

This segment discusses the critical metrics traders use to evaluate trades, highlighting the often-misunderstood concept of Probability of Profit (POP).

Defining Probability of Profit (POP)

Core Definition: POP is defined as the probability of making at least one penny at expiration.
Relationship with Strike Price: Selling out-of-the-money (OTM) options generally leads to a higher POP. The further OTM an option is, the higher its POP.
Inverse Correlation with Credit: A higher POP typically comes with a lower premium (credit received). This is often referred to as "low risk, low reward."

The Importance of Return on Capital (ROC)

Direct Reflection of Profit/Loss: ROC is presented as a more crucial metric as it directly reflects potential profits and losses, especially when considering trade management and portfolio volatility.
Defined Risk Trades: For defined risk trades like put credit spreads, ROC is calculated as the credit received divided by the maximum potential loss.
Undefined Risk Trades: For undefined risk trades (e.g., short puts, strangles), ROC is often viewed as the credit received divided by the buying power requirement. For example, a $200 credit on a $2,000 buying power requirement yields a 10% ROC.

The Trade-off Between POP and ROC

Inverse Relationship: It's generally impossible to achieve high values for both POP and ROC simultaneously due to their inverse correlation.
Bending the Rule with High IV: Selling premium in products with high implied volatility (IV) can potentially increase ROC. Higher IV leads to larger premiums collected relative to the buying power required for the trade.
Defined Risk vs. Undefined Risk: While the trade-off is more pronounced in undefined risk trades, it exists to some extent in defined risk trades as well, influenced by IV levels.

Strategies for Balancing POP and ROC

Out-of-the-Money Options: Using further OTM options with smaller deltas increases POP but sacrifices potential ROC.
Target ROC: A rough guideline for naked positions is to aim for 10-20% ROC if the trade reaches maximum profit. When managing trades at 50% of maximum profit, a target of 5-10% ROC is suggested.
Tasty Trade Style: The common approach involves selling premium in the 16 to 30 delta range, aiming for a POP between 60% and 80%. This balances collecting sufficient premium for a decent ROC with maintaining a relatively high POP.
Avoiding "Pennies in Front of a Steamroller": This idiom refers to selling options too close to the money (high delta) which, while potentially offering a high POP, can come with significant buying power requirements and volatility.

Impact of Implied Volatility (IV) on ROC

Higher IV, Higher ROC: Higher IV underlyings allow for increased ROC. For instance, a 20 delta put on an asset with 40% IV might offer double the ROC compared to one with 20% IV, assuming similar buying power requirements. This is because higher volatility means options are further OTM relative to the stock price, potentially reducing relative risk.

Understanding the Range of POP

This section delves into the mathematical boundaries of POP and its implications.

POP Formulae and Ranges

Maximum Possible POP: 100% minus the delta of the short strike. For a 30 delta put, the max POP is 70%. For buying a put, it's simply the delta (e.g., 30% for a 30 delta put). This represents the probability of making at least one penny.
Minimum POP (Probability of Touch): Two times the delta of the short strike. For a 30 delta put, this is approximately 60% probability of being "touched" (tested). This implies a 40% probability of losing on the trade.
Two-Sided Positions (Strangles): For naked strangles, POP is more dynamic. A 16 delta strangle has roughly a 68% probability of success (16% on the call side + 16% on the put side being outside the strikes).

Dynamic Nature of POP

Not Sticky or Static: POP is not a fixed value. It changes with market dynamics.
Expectation of Being Tested: Even with high POP trades, traders should expect their strike prices to be tested at some point. This is inherent in trading volatile markets.
Time Decay (Theta): While trades may be tested, time decay (theta) can still contribute to profitability over time.

POP Range Based on Delta and Volatility

Iron Condors: Iron condors with 30-40 delta short strikes have a wider range of true POP values compared to those with 10-20 delta short strikes, which have a narrower range.
Further OTM, Less Variance: As options move further OTM, their probabilities have less variance, meaning they are more predictable.
Closer to the Money, More Variance: ATM options have less "sticky" probabilities and experience more price movement, leading to greater variance.

Typical Tasty Trade POP Range

Sweet Spot: The typical Tasty Trade style short premium trade operates with a POP between 60% and 80%, corresponding to 20-30 delta short options for puts or strangles.

Misinterpreting POP in a Portfolio Context

This section addresses the common pitfall of misinterpreting POP when considering multiple independent trades.

Individual Trade POP vs. Portfolio POP

Independent Trades: Each trade's POP is calculated independently.
Portfolio Dynamics: The POP of a portfolio of multiple independent trades is not simply the average of individual POPs. Market dynamics can cause correlations between trades, leading to a narrower range of overall portfolio outcomes than expected.
Holistic Thinking: It's crucial to think holistically about the portfolio, acknowledging that high POP trades can still be tested, and multiple high POP trades might offset each other.

The Probability of Win Streaks

This segment explores how POP influences the likelihood of experiencing consecutive winning trades.

POP and Consecutive Wins

Reduced Odds of Streaks: Even with a high initial POP (e.g., 70-90%), a slight drop in POP (meaning the trade is being tested) sharply reduces the odds of achieving multiple consecutive wins.
Example: If a 90% POP trade's POP drops to 70%, the probability of a streak of profitable trades significantly decreases.
Decreasing Probability with More Trades: The probability of a win streak decreases as the number of trades in the streak increases. For example, a four-trade win streak at 70% POP has a much lower probability than one might intuitively expect, even if each trade is considered independent.
Expectation of Losses: This illustrates that even with high probability strategies, traders should expect positions to go against them at times.

Analogy to Coin Flips

Long-Term vs. Short-Term: While a coin flip is 50/50 in the long run, it's possible to flip 10 heads in a row. This highlights that short-term streaks, even against high probabilities, are not impossible.

POP is About Making a Penny

Not Max Loss or Tail Risk: It's important to remember that POP is the probability of making just one penny. It does not account for maximum loss or tail risk.
Variability of Wins and Losses: The variability of wins and losses, especially losses, is significant. The probability of realizing a specific amount of loss is highly variable.

Impact of Lower Initial POP on Streaks

Starker Drop: The lower the initial POP, the more dramatically the probability of consecutive win streaks drops.
Wider Distribution: Trading mostly 70% POPs results in a wider distribution of outcomes compared to trading mostly 90% POPs.
Parlay Analogy: This is likened to building a parlay bet, where each leg, even if individually high probability, significantly reduces the overall odds of winning the entire parlay.
Consecutive Hitting is Harder: Hitting things consecutively is significantly harder than achieving independent results.