Hi option traders. I hope you're having a great day. In this article I want to discuss standard deviations and probabilities as they are calculated by the popular options analytical software that is on the market. In the video that is attached to this article we are using software by Think or Swim. This is one of the most popular software programs in the world. It has a built-in feature to help us calculate probability of complex option strategies, but there is one thing missing when we use this feature. The software does not consider the current trend of the underlying that is being analyzed. Instead, the software always assumes that the underlying is trending sideways.
The technical traders out there know that these patterns and trends with technicalanalysis 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 consider a real trading example. If RUT is trending down and we set the standard deviation at the money, then the software might give us a probability of 79% for an Iron Condor. However, if the market is really in a down trend, is this probability really accurate? What do you think the correct probability is on this trade?
I've constructed a typical Condor in this video which is hopefully attached to this article. If it's not, then please visit Youtube.com/sjoptions. It's just 30 days out and I'm selling a 10 Delta, and I used a 10 point spread. This is a very common trade, and I'm not recommending this trade or anything like that. I don't do this type of trade myself. What I want to illustrate is that maybe the probability isn't as high as we think it is. In the video we are assuming that the software is calculating probability correctly, but in fact the software doesn't know the current trend in the underlying. The software shows this trade has a probability of 79%, but in reality that's only if the underlying is going sideways. 99% of your option traders assume this is the correct probability on this trade. But when they're making this calculation, they are completely throwing out technical analysis.
For example, if rain drops are falling from the sky, and they land on a flat and level surface, then the software is correct. However, if the rain drops land on a hill, then there's a higher probability that they'll splash downhill than uphill. Those of you that have traded stock and options for a while know how technical analysis works, and you'd agree that if the market is in a down trend, and if the software is analyzing for a sideways trend, then the probability calculation will be wrong. Look at the graph in the video and you'll see that the probability realistically is about 45% and not 79% as it appears to be. This is just an estimate but you get the idea.
Every experienced trader knows that the market normally trends in a direction, making the probability of the Iron Condor not as high as we believe. Those of us who believe in technical analysis should find a way to calculate probability using the trend combined with standard deviations. This would give us a more accurate analysis of the trade. As a final example, a bearish trade will actually have a higher probability in a bearish market than it appears to have in the options analytical software.
In conclusion maybe we should really ask ourselves: what are the factors that we should consider when we calculate probability for our option trades? Shouldn't we combine technical analysis with standard deviations? Or is the stock market really a flat and perfectly level playing field where trends do not exist?
The technical traders out there know that these patterns and trends with technicalanalysis 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 consider a real trading example. If RUT is trending down and we set the standard deviation at the money, then the software might give us a probability of 79% for an Iron Condor. However, if the market is really in a down trend, is this probability really accurate? What do you think the correct probability is on this trade?
I've constructed a typical Condor in this video which is hopefully attached to this article. If it's not, then please visit Youtube.com/sjoptions. It's just 30 days out and I'm selling a 10 Delta, and I used a 10 point spread. This is a very common trade, and I'm not recommending this trade or anything like that. I don't do this type of trade myself. What I want to illustrate is that maybe the probability isn't as high as we think it is. In the video we are assuming that the software is calculating probability correctly, but in fact the software doesn't know the current trend in the underlying. The software shows this trade has a probability of 79%, but in reality that's only if the underlying is going sideways. 99% of your option traders assume this is the correct probability on this trade. But when they're making this calculation, they are completely throwing out technical analysis.
For example, if rain drops are falling from the sky, and they land on a flat and level surface, then the software is correct. However, if the rain drops land on a hill, then there's a higher probability that they'll splash downhill than uphill. Those of you that have traded stock and options for a while know how technical analysis works, and you'd agree that if the market is in a down trend, and if the software is analyzing for a sideways trend, then the probability calculation will be wrong. Look at the graph in the video and you'll see that the probability realistically is about 45% and not 79% as it appears to be. This is just an estimate but you get the idea.
Every experienced trader knows that the market normally trends in a direction, making the probability of the Iron Condor not as high as we believe. Those of us who believe in technical analysis should find a way to calculate probability using the trend combined with standard deviations. This would give us a more accurate analysis of the trade. As a final example, a bearish trade will actually have a higher probability in a bearish market than it appears to have in the options analytical software.
In conclusion maybe we should really ask ourselves: what are the factors that we should consider when we calculate probability for our option trades? Shouldn't we combine technical analysis with standard deviations? Or is the stock market really a flat and perfectly level playing field where trends do not exist?
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