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Thursday, January 18, 2007

More On Options Probability Calculator...

I received an excellent comment by my friend, Ben, on the use of options probability calculator:

"Have you ever wondered why there is "85% probability" that the stock will be one side of a particular price point at a certain day?

First of all, the model assumes completely random direction every day from now until then.

And it uses the current Historical Volatility of the stock.

So if the stock has just had a big earnings jump and HV is high, then that tool will show you probabilities for very large distances.

If the stock has been very quiet lately and HV is low, the tool will be showing you a high probability that the stock won't move far.

However, if there is an upcoming news event like earnings, the stock actually will jump quite a lot, making the tool quite inaccurate.

Guess it helps to know how to take these things with a little salt ... being aware of how the stock's current Historical Volatility value compares to its likely future volatility will help you know if the tool is over or underestimating the future volatility of the stock."

In short, he summarized it this way:

"If the stock has been very quiet lately, and it's volatility could increase, perhaps due to news, the tool will be UNDERESTIMATING the distance the stock will move.

If the stock has just been jumping around, perhaps due to news events, and it can be expected to quieten down from here, the tool will be OVERESTIMATING the distance the stock will move.

The tool is unable to understand and predict the natural cycle of a stock's volatility changing with time."

Ben has rightly pointed out to use the calculator with care. My views? I would just like to add that as with any model, assumptions go behind it and in options pricing or modelling, volatility always plays an important role. I would personally prefer to use the probability calculator on an index (as illustrated) for the fact that it is more stable than an individual stock (no analyst upgrade/downgrade, earnings, M&A etc), and hence the probability more reliable. Having said that, a tool is just a tool and no tools out there can be 100% predictive. Even if the calculator is giving you near 99% probability of staying profitable in the trade doesn't mean you sink in your entire funds into the trade. At the end of the day, we still need to practice wise money management, set our stop loss and manage the trade once it is in place.


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