Probability Concepts For Iron Condors
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Today we'll be talking about standard deviation and probabilities when it comes to option trading. Most option traders use analytical software to analyze their trades before they put them on. But there's something that most traders do not think of. When we use standard deviations in the popular option software that is out on the market, we don't usually consider that the software is not aware of the current market trend. Most people that trade the stock market are aware of technical analysis. Well, your average options analytical software does not incorporate charting and trends when it calculates probability.
Every experienced option trader knows that technical analysis works. Obviously, we can never be 100% sure about the direction, but it's fair to say that we are right more times than we are wrong. Now, options analytical software calculates probabilities on the assumption that the market is always going sideways. It assumes that we are investing on a perfectly flat and level playing surface. This is not correct, so when we analyze our trades without thinking about technical analysis, we are not gathering an accurate probability.
Let's consider a real trading example. If RUT is trending down and we set the standard deviation at the money, then the software might give us a probability of 79% for an Iron Condor. However, if the market is really in a down trend, is this probability really accurate? What do you think the correct probability is on this trade?
This particular Iron Condor is a very typical one that is taught all over the Internet and can be found on the bookshelf at Amazon.com. But sadly enough this type of trade does not have the high probability that most option traders believe it does. Again, the reason is because the market does not trend sideways all the time. The software assumes that the market does, but in fact, the market usually trends up or it trends down. This lowers the probability of the Iron Condor considerably, and we should really be aware of that fact.
Let's talk about the rainy days. Imagine if a raindrop falls from the sky and lands on a perfectly flat and level surface. If this happens, there is a equal chance that the water will splash to the left or to the right. Now imagine if it's windy. If we throw some wind into the calculation, then there will be a higher chance that the water will splash the direction of the breeze. The same thing happens when the market is trending in one direction. There is always a higher probability that the underlying will move in the direction of the trend. Therefore, this Condor that appears to have a 79% probability, might only have a 45% probability when we consider the trend. It's very important to understand this concept because it can really improve your option trading.
If you look at price charts, you will notice that they normally trend up or they trend down, but they do not actually trend sideways for a very long time. The technical traders out there realize that trends can last for many months at times. If we find a way to use technical analysis combined with standard deviations, then we can perhaps arrive at a more accurate probability for our trades. Let's end with this thought. If we are in a bearish market, and we construct a trade to the downside, and we moved the standard deviation a little bit in that direction, then we will get a higher probability on that trade than we would if we placed the standard deviation at the money (ATM). If you truly believe in technical analysis, you might want to try this yourself.
In conclusion maybe we should really ask ourselves: what are the factors that we should consider when we calculate probability for our option trades? Shouldn't we combine technical analysis with standard deviations? Or is the stock market really a flat and perfectly level playing field where trends do not exist?
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