Recent spikes in both the statistical volatility and implied volatility for many securities make it a good time to look at the impact these changes have on Platinum Probability tools. Recall that the probability tools in Platinum make use of assumptions similar to those used in the Black-Scholes Option Pricing Model for European Style options, published by Fischer Black and Myron Scholes. These include (in statistical language):

1.  Security returns follow a normal distribution
2.  Volatility remains constant
3.  The expected mean return for the security is zero

A trader analyzing trades for QQQQ in mid-July will find that none of the three listed assumptions applied to the two-month daily returns for the security. So what impact would this have on profits/losses when using Probability of Profit as a ranking tool for trade evaluation? It depends.

Think about the shape of a normal curve (a.k.a. Bell curve) and how returns fit into that curve. The longest range bar typically includes the average daily return and the remaining bars taper down from this average value. Let’s assume this average is typically around 0.2% for the period. That means most returns will be +0.2%, but there will also be returns that are higher and lower than this value. The further away from this +0.2% you get (higher and lower), the fewer returns you’ll find in the corresponding bar.

However, during relatively volatile times you’ll probably find those more extreme bars start to get a little longer. The curve may begin to display one or two fat tails depending on the direction of the price trend for the period you’re reviewing. Or the entire curve can shift towards the more positive or negative returns (skewed). As you can imagine, the last 20 day period would likely favor the negative end of the curve.

If you’ve completed a longer-term trade using a lower Statistical Volatility [SV] level, the Probability of Profit did not account for this newly volatile period. The impact to your trade varies depending on the type of position created. One pretty interesting thing to see is the extent to which the price bars remain within the probability curves when you see the data forward in time. This isn’t always the case of course. It’s generally during times like these that the picture changes.

Viewing a Trade

To help get you started playing around with the tool, consider this put ratio back-spread for QQQQ which was selected based on its Probability of Profit rank on 8/18/2008.

-Buy 3 Oct 44 puts (QQQVR) at 0.70
-Sell 2 Oct 46 puts (QQQVT) at 1.18 for a net credit of $0.26

Use the 90-day SV of 23.74 when you view the Probability of Profit table and curves. Once you have a good feel for the trade risk and reward dynamics when initiated, play around with all of the different inputs including the date in the upper right hand corner. Be sure to consider the extent to which changes in implied volatility impact the total value of the position when moving forward in time.

Seeing It In Action

One of the best ways to address the issue of changing market conditions when evaluating new or existing options positions is to review the Probability of Profit and Probability curves under varying SV levels. You can also update the Rate of Return or Mean Stock Value in the Probability Calculator to reflect projected returns.

I think the best way to really get a feel for it is by playing around with the Probability Calculator tool. Vary the SV, time to expiration and return values independently and together to see where the curves are drawn and Probability of Profit registers.

For more detailed explanations on probability and Platinum tools, check out the Analytical Toolbox articles from August & September of 2006 written with John Broussard or the on-line Platinum Help Guide. Market conditions and some image issues prompted this article. The Platinum Money Management tools will be explored next month.

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Visit the Optionetics.com Discussion Board