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Thursday, June 28, 2012

Using Standard Deviation & Probability to Trade Options

From guest blogger J.W. Jones.....

I recently discussed the ability to use implied volatility to calculate the probability of a successful outcome for any given option trade. To review briefly, the essential concepts a trader must understand in order to make use of this helpful metric include......

The prices of any given underlying can be considered to be distributed in a Gaussian distribution the classic bell shaped curve.

The width of the spread of these prices is reflected in the standard deviation of the individual underlying’s distribution curve.

Plus / minus one standard deviation from the mean will include 68% of the individual price points, two standard deviations will include 95%, and three standard deviations will include 99.7%

A specific numerical value for the annual standard deviation can be calculated using the implied volatility of the options using the formula: underlying price X implied volatility

This standard deviation can be adjusted for the specific time period under consideration by multiplying the value derived above by the square root of the number of days divided by 365

These derived values are immensely important for the options trader because they give definitive metrics against which the probability of a successful trade can be gauged. An essential point of understanding is that the derived standard deviation gives no information whatsoever on the direction of a potential move. It merely determines the probability of the occurrence of a move of a specific magnitude.

Here's J.W.'s complete post and charts for "Using Standard Deviation & Probability to Trade Options"

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