There are many tradeoffs in life but the last one is the only one that concerns us as traders. The choice we make leads to which strategies we use and how frequently we use them. Large accounts can stick to “trade small trade often”. A tastyBITE account can trade small but trading often is a more difficult balance. What is the tradeoff between Return On Capital (ROC) and Probability Of Profit (POP)? Should tastyBITE traders allocate more to trades that require less capital but have a smaller POP?
A table was displayed listing three different SPY strategies; a short 1 Standard Deviation (SD) Strangle, a short Put with a 30 Delta and a long Call with a 30 Delta. The capital required, potential profit and probability of profit (POP) were listed. The margin, which equaled the capital requirement, for both the short Strangle and short Put were similar and relatively high for tastyBITE sized account. The long Call’s cost was just the cost of the Call and much lower. The Call had unlimited profit potential while the short Strangle and short Put were limited to the amount of the premium sold. The POP though for the short Strangle and short Put were 70% while the long Call only had a 26% chance of making money. Another table showed that while either the short Strangle or the short Put would only result in a Buying Power Reduction (BPR) of less than 2% in a $250 K account it would be well over a third in a $10K account.
A final table listed the chances of 1, 2, 3, and 4 consecutive losing trades for trades with a 50%, 60%, 70% and 80% initial POP at order entry . At 70% the chance of 4 consecutive losers is only 1% so the chance of a tastyBite sized account getting knocked out of the game is fairly low. This is a serious consideration for the traders with smaller accounts.
For more information on POP & ROC see:
Best Practices from February 2, 2015: "Key Metrics | POP & ROC"
Market Measures from March 30 2015: "ROC and POP | The Trade-Off"
Strategies For Your IRA from January 27, 2016: "Maximizing Return On Capital"
tasty BITES from May 10, 2016: "Maximizing Potential Return on Capital
Watch this segment of tasty BITES with Tom Sosnoff and Tony Battista for the important takeaways and an examination of the competing forces of probability and risk which is so important for the smaller trader and why we tend to stick with a high POP.
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