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Sunday, August 19, 2012

Implied Volatility and Probability

Okay, I'm just beginning to wrap my head around the Tom Sosnoff/Tom Preston view of trading. And it makes a lot of sense to me.

You have to accept (first of all)that the market is fairly priced and efficient, and dispense with the idea that some ogre market maker is out to screw you. (providing, of course, that you are trading liquid stocks that have buyers/sellers in abundance). You MUST have high frequency trading in order for the suppositions to work.


So, let's say that you decide to SELL a strangle on AAPL when it's selling for $598.75. Let's say that this is an earnings play, (meaning that we KNOW IV will contract after earnings).

Looking at the chart, and the Standard deviation channels, I can see that ONE STANDARD DEVIATION upward from the price is $658.94, and downward from the price is $538.77.

(if you must know, a standard deviation equals the price x the implied volatility x the square root of the days until expiration divided by the days of a year. Fortunately the Think or Swim software calculates this for us!).

Looking at the option chain, using strike prices that are one standard deviation away from the money, the "Prob OTM" (Probability of being out of the money at expiration) is 68.2%.

Looking at the slide above, take a look what happens when the Implied Volatility drops down to a "normal" level of implied volatility of 25%. THE PROBABILITY GOES UP!!

I don't have the kind of money to SELL Strangles, but this is a good argument for NOT buying LONG Strangles. Unless you know enough to sell them very quickly before the implied volatility contracts right after earnings.

But this is a great lesson in understanding WHY you should know and understand both volatility and probability when trading options.

So, based on the slides above, it makes more sense to be a Seller than a Buyer of options, and if you MUST be a Buyer, do it in times of Low Volatility when your probabilities increase!


Wednesday, August 15, 2012

Tasty Trade is tasty indeed!

Okay, Think or Swim is really serving me well. It has more bells and whistles than a steamship, the more I learn about it (and how to use it), the more I appreciate the deft sophistication of this platform. And after reading a bit of its history, I am really excited to know that I currently have access to its founder, one of the giants in option history.

Tom Sosnoff, CEO, tastytrade, host of Get Tasted
Photo: Saverio Truglia Photograph

"Tom Sosnoff, CEO of tastytrade and host of “Get Tasted,” is a recognized online brokerage innovator and sought-after financial educator. Tom founded thinkorswim in 1999, before the options market was electronic. Leveraging over 25 years of experience as a market maker for the Chicago Board of Options Exchange (CBOE) and one of the original OEX traders in the S&P 100 Index pit, Tom pursued a vision to educate retail investors in options trading and to build a superior software platform at a brokerage firm that specialized in options. His efforts ultimately changed the way these instruments traded by pioneering single click trading functionality for complex spreads.

Under Tom’s leadership, thinkorswim evolved into the leader in daily retail options trading, and a pioneer in investor education services for options, futures and FX trading. Tom led the company’s corporate strategy and was dedicated to systems development and trading innovations. He continues to advance understanding of the active trading marketplace by personally teaching and executing complex, non-directional option strategies for investors and traders at all levels."

Tom's co-host and sidekick is Tony Battista.

Tony (known also as "Bat") started his 22-year career in options and futures trading in 1983, as an independent Market Maker at the Chicago Board Options Exchange (CBOE), as well as a local independent trader at the Chicago Board of Trade (CBOT), where he traded the 30-year bond future. While primarily an independent trader in the S&P 100 Index (OEX, XEO) pit, he also spent three years in the AOL equity pit. He served on the CBOE arbitration committee for over 10 years, ruling on disputes between traders and trading firms, prior to joining thinkorswim.Presently he is Co-Host with Tom Sosnoff "Get Tasted" on the tastytrade network the #1 ranked financial program on the internet.


The tastytrade Network was founded in May 2011, as an Internet-based channel for original financial news, investment strategies, and entertainment for the masses, with programming geared to various investment levels, from beginner to professional. Members get access to exclusive programming, trade ideas, plus significant discounts to investing products and services.

tastytrade currently produces seven hours of original, live programming every weekday, with “Get Tasted,” “The Liz & Jenny Show,” “Ask Slim,” “Last Call,” and “Sneek & the Geek.” tastytrade is available at www.tastytrade.com, on iTunes, Apple TV, Apple Radio, and on Roku. Programming is archived, cataloged and accessible 24/7 at tastytrade.com.


Normally it runs about $95 per month, BUT if you go to their tastytrade.com website and open a Think Or Swim (TD Ameritrade) brokerage account (via tastytrade) you will get a 2 year FREE membership to tastytrade, PLUS a new account which is funded with $2000 is eligible for 300 FREE TRADES. THAT is a bargain~!


Believe it or not, just as Tom was inspired to change option trading to an online, click and trade innovation, he is now equally inspired to teach the normal joe and jane HOW to trade his way, making option trading a mechanical "odds-driven" probability profession where, with enough training, one can make more wins than losses and actually earn money trading options. He believes in selling premium, and is not a buyer of options in the typical way of only buying calls or puts. He teaches spread trading and Think or Swim supports his views in its design.

You could do a lot worse than listen to this man and his team, his lessons, his philosophy, and his wisdom. Plus tastytrade is FUN. There is a lot of good ol' boy banter, humor, games and interviews thrown in with the heavy duty tasks of learning to trade options.


One of my favorite sections of the shows is called "Market Measures" where Tom and Tony actually demonstrate and teach a facet of options trading.

These are the slides from one of the recent shows, telling how you can compute the probability of a trade making at least a one cent profit. (i.e., not losing). It would take a much longer blog entry to elaborate on this particular show, but as a teaser, I thought I'd post a few of the slides. POP stands for Probability of Profit.

Of course, without the Tom/Tony demonstration (you can find it on the tastytrade.com website) these slides may look a bit opaque. Even with the verbal and visual aids, I found myself a bit confused, but if you take time to break it down, it makes more sense. The simplest for me was the Vertical Spread.


Let's say GS stock is at $103.26.

I SELL a Sep call at Strike $105 for $2.18; I BUY a Sep call at Strike $110 for $.79; Thus I receive premium of $1.39

Using the formula in the above slide, I divide my premium ($1.39) by the width of the strikes ($105 less $100 = 5) So, $1.39 divided by 5 equals .278

Multiply by 100 (.278 x 100 = 27.80)

Subtract from 100 (27.80 minus 100) = 72.2% probability.

Now just for fun, I went to the Options Chain on ThinkorSwim to look at the probability of this $105 Strike going in the money. Think Or Swim's calculation for staying OTM (thus safe as a credit spread) is 61.22%

I don't know why these are not closer, so I have zipped off an email to Tom and he will answer it. I could also CALL the show during their segment where they accept callers with questions. It a direct pipeline to professional traders. Free. It's an amazing gift.

I'll let you know what he says.

But you need to check it out for yourself -- there's all kinds of different trading programs on tastytrade, including "Cherry Beans" where they pay you $1 for every successful trade you make! (up to $30 per month). It's all fun and inspiring.

P.S. I heard back from Tom. The 61.22% number from the options chain is the probability of being at least one cent Out of the Money at that strike price.

The 72.2% number is the probability of being out of the money on the breakeven number on the spread.

So, if I understand this correctly, there's a 61.22% probability that $105 will not be in the money at expiration.

And there's a 72.2% probability that the breakeven ($106.39) will not be in the money at expiration.