Probability Calculator for Options Trading

2008 Parkwood Capital, LLC, all rights reserved

Data Input: Price: Target Price: Implied Volatility: Days to Expiration: $45.00 $55.00 152.00 46

Enter as a percentage, e.g. 12.45, not 0.1245

One Standard Deviation () Move = Probability of Stock Price Closing Above the Target Price: Probability of Stock Price Closing Below the Target Price: One One

$24.28 35.5% 64.5% $69.28 $20.72

Above the Current Price: Below the Current Price:

This calculation is based upon the assumption that stock prices behave according to a normal or Gaussian distribution (the classic bell shaped curve). Think of todays stock price as the peak of the bell shaped curve. The normal price distribution illustrates what we know intuitively, i.e., a larger move in price to the edges of the distribution curve is less likely. These calculations simply let us quantify the probabilities of our price estimates. If we were analyzing a stock's historical price behavior, we would use the stock's historical or statistical volatility in the distribution calculation. Since we are estimating the stock price movement for the future, we will use todays implied volatility for the stock's options as the market's best estimate of the stock's future volatility. Therefore, we can use the implied volatility as an estimate of the standard deviation for the price distribution calculation. For a normal distribution, the probability of the data point being contained within plus or minus three standard deviations of the mean is 99.74%. Similarly, a one standard deviation move in either direction should encompass 68% of the data. These calculated probabilities are the accurate predictions for a series of random events such as computing the probabilities of rolling a seven when playing dice. If stock prices behaved as statistically random events, like flipping a coin, one would expect stock price moves outside of the plus or minus three standard deviations to be an extremely rare event (only a 0.26% probability). In fact, it isn't. This is the so-called "fat tails" problem, i.e., the far ends of the distribution are higher or fatter than predicted. Stock prices are subject to many non-random forces - news events, crowd psychology, etc. Thus, stock price moves of greater than three standard deviations occur far more often than predicted. Therefore, do not look at these calculated probabilities as precise predictions of the stock price. But we could expect these probabilities to be more and more accurate if we were placing similar trades one after another. We can also use these probabilities to compare the relative risks of various trades. For example, one could compute the probability of the stock price closing above the sold strike price for a series of potential

covered call trades, and rank them on this basis. This form of a probability calculator can be used with many different options strategies. For example, if we are considering an OTM bear call spread on the SPX and want to know which strike prices to use for a high probability trade, we would enter the current price of the SPX, $1305, the current IV of 11.5% and 15 days to expiration, and calculate one standard deviation of $30 (the Greek letter, sigma (), is traditionally used to signify a standard deviation in statistics; thus, in this example, = 30). Therefore, a bear call spread at $1335/$1345 would be over one standard deviation away from the current price and would have a probability of about 84% of the SPX closing below $1335 in 15 days (68% for the area of plus or minus one , or $1275 to $1335, plus the area below $1275 which has a 16% probability). One could extend this calculation to an iron condor spread by establishing the bull put spread at $1265/$1275. Thus, both spreads are about one standard deviation away from the current price and this trade has a high probability of success. Using this system over time, one would expect to have winners about 80% of the time; however, the key success factor is managing the losses the other 20% of the time. Couple this technique with a solid stop loss discipline for a robust trading system. For more details and background, see: Options as a Strategic Investment, Larry McMillan, pages 456-489 A good source for implied volatility data is the CBOE web site: www.cboe.com, trading tools-IV Index Kerry W. Given July 25, 2008

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