Realistic and Theoretical Probability – A New Approach To Option Trading
Hi, in our last conversation we talked about back-testing and how important that can be. Today, we are going to compare Realistic and Theoretical Probability.
Theoretical Probability of Profit (POP)
When we say Theoretical Probability, we are referring to the mathematical probability that is implemented into most options analytical software which is based on standard deviations and the bell curve. Many option traders use one, two and three standard devations to determine their probability to make money on a trade. Although this is a common approach, it has serious flaws that are very commonly overlooked.
The first problem is that this type of analysis doesn’t factor in risk. For example, a typical spread may have a theoretical probability of 85% at expiration, but this 85% contains a lot of real estate that requires the trader to take on tremendous risk during the life of the trade. In most instances, 50% of the theoretical probability is in a High-Risk-Zone by SJ Options’ standards. In other words the popular trades that have a POP (probability of profit) of 85% or higher only have a RPOP™ (realistic probability of profit) of about 42%.
The other problem with the common analytical tools is they assume the Bell Curve Center is right at the money. This is wrong. Our software shows where the actual center really is for each product, and it’s quite often not right at the money. So, this also throws off the probability analysis of each trade.
Realistic Probability of Profit (RPOP™) = Probability of Safety
Each trade has a Theoretical Probability which contains a safety zone within that total probability that we at SJ Options have coined as the Realistic Probability of Profit or RPOP™.
When we think in terms of the RPOP™, we are referring to the probability of safety. This is the realistic probability of each trade since the area outside of this zone forces the user to take on great risk. We believe it’s unrealistic to include an area within the probability that is not safely usable.
When we trade options, it’s very important to understand the difference between these two probabilities. If you only look at your Theoretical Probability, you’ll run into problems over and over again. Many adjustments will be required once outside the safe zone, and in this business, we do not always get filled on our trades. This happens a lot to people who trade with limit orders while they are working full-time at another job. If you miss an adjustment, it can cost you thousands of dollars.
This is why it’s very important to increase your Realistic Probability as much as possible when you trade options. By having a larger safety zone, you can trade safer, and you won’t be making as many adjustments. Your overall risk will be greatly reduced, and your true probability of each trade will be greatly increased which means more money in your pocket at the end of the day.
See the image to illustrate the Theoretical and Realistic Probabilities of a traditional Iron Condor.