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I recently discussed the ability to use implied
volatility to calculate the probability of a successful outcome for any given
option trade. To review briefly, the essential concepts a trader must
understand in order to make use of this helpful metric include:
- The prices of any given
underlying can be considered to be distributed in a Gaussian
distribution- the classic bell shaped curve.
- The width of the spread of
these prices is reflected in the standard deviation of the individual
underlying’s distribution curve.
- Plus / minus one standard
deviation from the mean will include 68% of the individual price points,
two standard deviations will include 95%, and three standard deviations
will include 99.7%
- A specific numerical value
for the annual standard deviation can be calculated using the implied
volatility of the options using the formula: underlying price X
implied volatility
- This standard deviation can
be adjusted for the specific time period under consideration by multiplying
the value derived above by the square root of the number of days divided
by 365
These
derived values are immensely important for the options trader because they
give definitive metrics against which the probability of a successful trade
can be gauged. An essential point of understanding is that the derived
standard deviation gives no information whatsoever on the direction of
a potential move. It merely determines the probability of the occurrence of a
move of a specific magnitude.
It is
important to note that no trade can be established with 100% probability of
success; even boundaries of profitability allowing for a three standard
deviation move have a small but finite probability of moving outside the
predicted range. A corollary of this observation is that the trader must
NEVER “bet the farm” on any single trade regardless of the
calculated probability of success. Black swans do exist and have a nasty
habit of appearing at the most inopportune times.
Let us
consider a specific example of a “bread and butter” high
probability option trade in order to see how these relationships can be
applied in a practical manner.
The
example I want to use is that of an Iron Condor position on AAPL. For those
not familiar with this strategy, it is constructed by selling both a call and
put credit spread. The short strikes of the individual credit spreads are
typically selected far out of the money to reduce the chance they will be
in-the-money as expiration approaches.
I want to
build an iron condor on AAPL in order to illustrate the thought process. As I
type, AAPL is trading at $575.60. August expiration is 52 days from today;
this is within the optimal 30-55 day window to establish this position.
Consider the high probability call credit spread illustrated below:
This trade
has an 88% probability of profit at expiration with a yield of around 16% on
cash encumbered in a regulation T margin account.
Now let us
consider the other leg of our trade structure, the put credit spread.
Illustrated below is the other leg of our iron condor, the put spread:
This trade
has a 90% probability of profit at expiration with a yield of around 16% on
cash encumbered in a regulation T margin account. As the astute reader can
readily see, this put credit spread is essentially the mirror image of the
call credit spread.
When
considered together, we have given birth to an Iron Condor Spread:
The
resulting trade consists of four individual option positions. It has a
probability of success of 79% and a return on capital of 38% based on regulation
T margin requirements. It has an absolute defined maximum risk.
Note that
the probability of success, 79%, is the multiplication product of the
individual probabilities of success for each of the individual legs.
This trade
is readily adjustable to be reflective of an individual trader’s
viewpoint on future price direction; it can be skewed to give more room on
either the downside or the upside.
Another
characteristic and reproducible feature of this trade structure is the
inverse relation of probability of success and maximum percentage return. As
in virtually all trades, more risk equals more profit.
I think
this discussion illustrates clearly the immense value of understanding and
using defined probabilities of price move magnitude for option traders.
Understanding these principles allows experienced option traders to structure
option trades with a maximum level of defined risk with a relatively high
probability of success.
Happy
Option Trading!
JW
Jones
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