Today we’ll be talking about standard deviation and probabilities when it comes to option trading. Most option traders use analytical software to analyze their trades before they put them on. But there’s something that most traders do not think of. When we use standard deviations in the popular option software that is out on the market, we don’t usually consider that the software is not aware of the current market trend. Most people that trade the stock market are aware of technical analysis. Well, your average options analytical software does not incorporate charting and trends when it calculates probability.
The technical traders out there know that these patterns and trends with technical analysis are pretty consistent. When we are looking at standard deviation charts, and we are using software to calculate probabilities, the software does not know the current trend. It is assuming that we are just going sideways. It’s assuming that there’s an equal chance for that object to fall to the left or to the right. But when it comes to trading options, it’s not like that because we do have patterns.
Let’s look at an example. If the market is trending down, and we are using software that assumes the market is trending sideways, then the probability calculation for that trade will not be accurate. In this video we are looking at a Condor spread which is at the money. The software shows it has a probability of the about 79%; however, if the market is really trending down, then is this probability really accurate? What is the true probability on this trade?
This particular Iron Condor is a very typical one that is taught all over the Internet and can be found on the bookshelf at Amazon.com. But sadly enough this type of trade does not have the high probability that most option traders believe it does. Again, the reason is because the market does not trend sideways all the time. The software assumes that the market does, but in fact, the market usually trends up or it trends down. This lowers the probability of the Iron Condor considerably, and we should really be aware of that fact.
Let’s think about the rain. When rain falls from the sky, does it always lands on a perfectly flat and level surface? If it does, then the calculations of probability by placing the standard deviation at the money would be correct. However, consider this. What if the rain drop land on a slanted hill? If this is the case then most likely the water will splash downhill and not uphill. Now if you look at this video, you will see that this Condor appears to have a very high probability, but if we move the standard deviation to the left because we are in a bearish market, then the probability is substantially lower. In fact it might only be about 45%. We are just estimating here, but it’s important that you understand the concept.
If you look at price charts, you will notice that they normally trend up or they trend down, but they do not actually trend sideways for a very long time. The technical traders out there realize that trends can last for many months at times. If we find a way to use technical analysis combined with standard deviations, then we can perhaps arrive at a more accurate probability for our trades. Let’s end with this thought. If we are in a bearish market, and we construct a trade to the downside, and we moved the standard deviation a little bit in that direction, then we will get a higher probability on that trade than we would if we placed the standard deviation at the money (ATM). If you truly believe in technical analysis, you might want to try this yourself.
I will finish by saying that maybe we should really ask the question: what factors should we include in our calculation when we analyze the probability of an option trade? Should we throw technical analysis out the window and always assume that there is an equal chance for the stock market to go up or down at any given time? When it rains, how often do rain drops land on a perfectly flat and level surface? Do they ever?