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February 2007

money, there are many substitutes, each with drawbacks, primarily what estimate of

volatility to use. I was short S&P March 1500 calls, so I'll use those as examples after

each, and let you decide validity...

- Probability, based on standard deviation - 1.6 standard deviations away, where 1 std dev

is 68% confidence, and 2 std dev is 95% confidence. Except that stock prices don't

follow a normal distribution, they have fat tails, and a higher peak in the center

(leptokurtosis!) so std dev models overprice near-the-money options and underprice far

out-of-the-money options. A cheap and easy approximation to find the 1 std deviation

based on the implied volatility of the options prices, is to add the ATM put and call

together and multiply that result by 1.25. The formal calculation of std dev = stock price

x volatility (I use the 20-day historical or statistical vol) x square root of time to

expiration, expressed as fraction of a year. Alternately, 1 std dev can be figured

substituting implied vol for statistical vol = stock price x implied vol (use ATM call) x

the square root of the time to expiration, expressed as a fraction of a year.

- Probability, based on log normal distribution - 9.2 %. Better, but still relies on an input

for volatility - again, using 20-day historical volatility. See attached doc for the maths,

including the 5th order polynomials... I put together an excel spreadsheet for these.

finishing ITM, when volatility is less than 50% and there are less than 70 days to

expiration. The lazy man's estimate, as it can be found at futuresource.com for S&P 500

futures options.

- Monte Carlo simulation - 18%. There is one proprietary calculator that I like. I use the

Larry McMillan calculator which tells you the probability that your option strike will

ever be crossed before expiration- which is what you really care about, because prudent

money management dictates that you close losers at some point before they wipe you

out. So, while the probability at expiration is definitely useful, the probability for any

time between now and then is more useful. This probability generally doubles the

probability of finishing ITM.

All Rights Reserved

Eric Hartford

February 2007

where

d1 = ln (p/s) + ( r + v 2 / 2)t

v√t

and

d2 = d1 - v√t

p = Underlying current price

s = Option strike price

t = time to expiration as a percentage of a year = days to expiration / 365

r = risk free interest rate (30-yr bond) assumed to be 5% for simplicity

v = volatility as annual standard deviation, known volatility used to calculate OPt

e = 2.71828

ln = natural logarithm

√ = square root

iv = implied volatility, found using actual option price and solving for v

N(x) = cumulative normal density function of x

and

N(σ) = 1 – x if σ < 0

and

y= 1

1 + .2316419 | σ |

and

z = .3989423 e – (σ * σ) / 2

and

x = 1 – z (1.330274y5 - 1.821256y4 + 1.781478y3 - .356538y2 + .3193815y)

2) the probability* that a given option will finish in-the-money (ITM)

3) amount an option will change in price as a ratio to the underlying

*For options less than 70 days to expiry, with v < 50%, not including dividends

All Rights Reserved

Eric Hartford

February 2007

Probability of stock finishing above strike price

=1-NORMSDIST(LN(Strike/Tradeprice)/(historicalvol*SQRT(Daystoexp/365)))

Delta of a put

=NORMDIST((LN(Tradeprice/Strike)+(Rate+Impvol^2/2)*Daystoexp/360)/(Impvol*SQ

RT(Daystoexp/365)))-1

Delta of a call

=NORMDIST((LN(Tradeprice/Strike)+(Rate+Impvol^2/2)*Daystoexp/360)/(Impvol*SQ

RT(Daystoexp/365)))

The actual probability of a given underlying instrument finishing above a particular strike price

is;

v√t

Delta can be a useful approximation of the likelihood that a given strike will finish in the money.

This has been one of my key assumptions about options trading, so it is useful to examine it in

detail

Let me cite some references to back up my impression that delta is an approximate probability

that a given option will finish in the money at expiration. I picked up the idea from Jay Kaeppel

when he came to our Atlanta Options Investors meeting in November of 2003. I had previously

read one of his books that touched on this and he reinforced it at the meeting.

He states in The Option Trader's Guide to Probability, Volatility, and Timing first edition, page

89, "The delta value for a given option provides an estimate of the probability that the option will

expire in the money. Thus an option with a delta of 20 currently has a roughly 20% probability of

expiring in the money (although this is not mathematically correct, it does provide a useful

estimate and a valuable frame of reference). "

On page 97, Jay Kaeppel writes, "As a simple tool, an option's delta value serves as a handy

estimate of the likelihood that it will expire in the money."

Strategic Investment , 4th edition, page 967 under the definition of Delta, we find " (2) the

percent probability of a call being in-the-money at expiration." He references this only briefly in

the Chapter 40: Advanced Concepts text on page 848. "In another context, the delta of a call is

often thought of as the probability of the call being in-the-money at expiration. That is, if XYZ is

All Rights Reserved

Eric Hartford

February 2007

50 and the January 55 call has a delta of 0.40, then there is a 40% probability that XYZ will be

over 55 at January expiration."

In context, both these references have the air of hearsay that is being passed on, but not refuted.

Neither claims that the delta is the equivalent of the probability for all options, and one should not

make that claim, without additional explanation. There is an ease of use (lazyness?) issue in

taking one of the existing greeks that is provided by the brokers and using it as an approximation.

One should favor doing the actual probability calculation. And it is an easier calculation in that it

has fewer terms.

The probability formula from McMillan is a little fuzzy, but using the same divisor as the delta

formula seems permissible, and I like it for giving the instantaneous market price implied value,

rather than the historical.

Numerically, I would note that the interest rate risk plus half of the implied volatility squared all

multiplied by the time remaining to expiration could throw off a number that could be overlooked

in an approximation that was plus or minus 3%, as long as:

1) the options in question are near term (within 70 days). Obviously the closer one gets to

expiration, the more accurate this approximation becomes.

2) the implied volatility is below some limit (.5). This is the dangerous assumption, because as

options traders, we are looking for extreme volatilities.

If my memory of natural log functions isn't too faulty, ln (a/b) = - ln (b/a), so the transposition of

the the natural log of trade price over stock price in the delta calculation versus the stock price

over trade price in the probability calculation is solved by stating that probability should be an

absolute value or always positive.

While the following doesn't make the case at all (because 4+1=5 and 3+2=5 does not mean that

4=3 or 1=2) it is worth noting that,

and

Black Scholes option maths have many limitations, chief among them that they primarily

apply to European-style options (only exercised or assigned at expiration), not options

exercise-able/assignable any time (American style). Other models superceded Black-

Scholes in the 15 years since these calculations were the state of the art. However, it is

useful to know this work and the contributions of Merton, Cox, Rubenstein and others.

Special thanks and credit to Larry McMillan, Jay Kaeppel and Joe Murad for their work

in the field, particularly Joe Murad for his efforts sustaining Atlanta Options Investors.

All Rights Reserved

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