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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.

WHAT HAPPENS TO PROBABILITY WHEN IMPLIED VOLATILITY CHANGES?



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!

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