Standard Deviation, Expected Move,
& Market Maker Move.
Options do use math, some very complex math, but once you understand the objectives and logic behind it, at least conceptually, it becomes something we can really use to our benefit- but math none the less. Every time I find myself putting pencil to paper to work out this math, and riddled with memory's from not paying attention in high school/College math,- its retribution in some form, and now I am *choosing* to do it every day, its amazing how the tables have turned. Back then the only objective was to copy someone else's work as fast as possible to have something to turn in. I didn't understand where X or Y was, nor cared, or even knew how to go looking to solve for them, and the practical reasons for why- was never fully explained to me. I remember asking; "what is this needed for?" and the teachers answer with a smirk already impressed with his own level of wit responded with: "So you can pass this class!"
In this article we are going to be showing what a standard deviation is, and a few ways to calculate that number and why is beneficial and useful to an option trader.
Option math, trade school, FOCUS!
There are a few things that professional option traders know like the back of their hand, one being that 15.87 is the square root of 252.
Anyone that has any realistic professional exposure to the option world, will concur this is one of the first things pounded into a new traders head.
Any past flip of heads or tails has no future relation to the next flip. The odds of a heads because the last flip was heads does not directly relate to the current flip. Each flip is *independent* of its own, while the odds of a string of heads or tails does have different odds, each flip has a stand alone measure is 50/50 odds. Bets here are not played on a per string basis.
Anyone that has any realistic professional exposure to the option world, will concur this is one of the first things pounded into a new traders head.
Set aside everything you have ever been taught about "Trend following" and what you "Think" will happen next, and step back from trading for one instant and relate this to a simple 50/50 coin flip. If we can ignore past bias, history, and news- underlying's can only do one of three choices, up, down or sideways.
Any past flip of heads or tails has no future relation to the next flip. The odds of a heads because the last flip was heads does not directly relate to the current flip. Each flip is *independent* of its own, while the odds of a string of heads or tails does have different odds, each flip has a stand alone measure is 50/50 odds. Bets here are not played on a per string basis.
Approaching trading with any additional baggage besides the above mentioned realities will make the unbiased trader turn into the compulsive gambler, and the gap widens between the two rather fast. Please consider the above coin game, if we were flipping for a cash wager and I say:
Let's make *ALL* directional assumptions, and currently held positions, or experience with an underlying be second place to this discussion. This is *not* talking about what is cheap or expensive, but rather approaching this from a ZERO point of view.
"We gotta bet big because the last one was heads, the next one has gotta be tails!"
How is this any different from saying:
"We gotta bet big because the last one was heads, and the next one has gotta be heads again?"
Traders who feel its "Gotsta GO" one way or the other, fall into the above trap. That assumption needs to be secondary, not primary to the framing of a trade, its as foolish as upping your bet on the coin flip not realizing you have no real additional edge at that point.
In the early 2000's I lived in Las Vegas Nevada, and shortly around that point noticed all casinos added this electronic number counter to all the roulette wheels, keeping track of where the last ball landed, if there was a string of RED's people walking by the table would get engaged and bet BLACK, or vise versa, do we really think the casino is going out of its way to publish odds against itself, or is it the best engagement tool to get people to bet on a game they would have typically just walked by if not suckered into the gamblers fallacy? As well as enforcing table betting limits to curb any martingale betting strategy these approaches are already D.O.A.
Let's make *ALL* directional assumptions, and currently held positions, or experience with an underlying be second place to this discussion. This is *not* talking about what is cheap or expensive, but rather approaching this from a ZERO point of view.
All Option traders should burn the above image into their brain.
For those that don't already understand what a bell/gaussian/normal distribution curve is, lets give some examples.
Lets imagine we set up a speed trap radar on any particular street and record the speed of each passing car. Most of the data will be around some speed (Median) or central value (MU) on the center line in the above picture. For example lets say we have 100 data points, or the speed of 100 cars within the recorded time. Within the data points we might have had one 90 year old driver rolling down the street at 10mph, while some 16 year old might have been going 100mph. these would be considered outliers. But most of the data will be wrapped around some median. For the sake of discussion of the average of all the data points was about 50mph. Going higher then that number and lower from that number to a point in which we are encompassing 68.2 percent of all data points would be at one standard deviation of the data set.
That is one example- there are many, these distribution curves show up everywhere, and in the above it was done with individual drivers, but in the stock market it will be done with what we consider snap shots in time throughout the option cycle. We are going attempt to combine the previous coin flip example with the driving distribution and apply it to the stock market and we get something called a binomial tree. If we can imagine every trade tick positive or negative, red or green as a coin flip heads or tails, each aggressive participant would equate to a flip, (willing to pay the bid ask spread) Thus cause the underlying to tick up or down.
Options have a few different components that make up their price, in this case we are referring to its volatility, and time.
If we can combine these factors and determine where its one standard deviation is at, we can determine the exact location where the stock will spend over 68.2 percent of its life, or at least what the sum total of every option market participant is pricing or expecting facebook to do within this next cycle.
as of the exact time of writing this FACEBOOK is trading at $32.09 the current front month contract has 23 days remaining (17 actual trading days) , and its volatility is trading at 52.70%
the formula to determine one Standard Deviation is as follows
Stock price * Vol * Square root of trading days left in contract (excluding weekends) / total trading days (252 excluding weekends)
17 squared = 4.123
252 squared = 15.87*
4.123/15.87 =.2598 * (Stock Vol) .5270
.015925 * (Stock Price) = $4.39 so this is telling us that Facebook within the next 23 trading days will spend 68.2 % of its life + or - $4.39 or between $27.70 and $36.48
That is one of many ways to determine this number.
Once we learn to trust this number, we can see this is the location in which we want to move our risk past, meaning if we were to buy options at the 27.70 puts or 36.48 calls (if that exact strike existed) would equate to nothing more then a 31.8 percent chance of success. It becomes a real up hill battle, but this is actually where we want to place our risk, because then that 68.2 percent chance starts working for us.
Second low down and dirty way of determine this number.
If we do not have access to an individual option chains net volatility, what we can do is use the option Strikes Delta.
Delta is roughly translated into the odds of this strike actually ending its life in or out of the money.
most people intuitively think they must be looking for a Delta of 34.1 and they have found the one Standard Deviation, but that thinking would be incorrect.
If we can go back and reference the original bell curve above and add together the first three quadrants: 0.1% +2.1% +13.6 % = 15.8 give or take 16ish
just eye balling the option chain to a option out of the money with around a 16 Delta will ball park your one standard deviation move. Right now looking back at the Facebook option chain the 16 Delta option is currently at 28 strike on the downside 36 50 ish on the upside.
If we do not have access to an individual option chains net volatility, what we can do is use the option Strikes Delta.
Delta is roughly translated into the odds of this strike actually ending its life in or out of the money.
most people intuitively think they must be looking for a Delta of 34.1 and they have found the one Standard Deviation, but that thinking would be incorrect.
If we can go back and reference the original bell curve above and add together the first three quadrants: 0.1% +2.1% +13.6 % = 15.8 give or take 16ish
just eye balling the option chain to a option out of the money with around a 16 Delta will ball park your one standard deviation move. Right now looking back at the Facebook option chain the 16 Delta option is currently at 28 strike on the downside 36 50 ish on the upside.
Trying to turn this
Into this mentally
