subject: Probability Concepts For Iron Condors [print this page] 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.
A Study of Iron Condor Probability and Standard Deviations
Experienced traders of the stock market know that stocks tend to trend in patterns. They certainly do not trend sideways for very long. The software, however, places the standard deviation at the money (ATM) by default. If the person using the software uses this default setting for every trade, then they may be missing something very important. It's very possible that the probability calculations will be off by quite a bit.
Let's look at an example. If the market is trending down, and we are using software that assumes the market is trending sideways, then the probability calculation for that trade will not be accurate. In this video we are looking at a Condor spread which is at the money. The software shows it has a probability of the about 79%; however, if the market is really trending down, then is this probability really accurate? What is the true probability on this trade?
This Iron Condor strategy is very popular in the options trading community, and one reason is because everybody thinks it has a very high probability. But the truth is the probability on this trade is not near as high as we think it is. The reason being that the market does not trend sideways for very long. In fact, if you look at a price chart, you will see that the market normally trends up or it trends down. This makes the probability of an ATM Condor much lower than it appears to be.
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.
We all agree that the markets often times are trending up or down. That is no mystery. So why not try to incorporate technical analysis into our calculations of probability when we analyze our option strategies? This could perhaps give us a more accurate reading and improve our trading skills over a long period of time. One way to do this in the Think or Swim software is to simply change the price of the underlying on the bottom right below the risk graph. This will help to give us a more accurate probability analysis.
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?
