By: Spencer Enos
Many College Finance programs focus strongly towards fundamental analysis. In fact, most Financial Institutions rely heavily on using fundamental analysis for order execution. The only problem… no fundamental analysis provides a statistical edge in the market. Fundamental analysis is a way to stay engaged in the market, not a way to participate.
Quantitative Analysis represents sophisticated mathematical and statistical modeling to predict outcomes. Through the use of option greeks, standard deviation, and implied volatility, a portfolio can create probabilistic outcomes. This means a portfolio can be constructed to be right 99% of the time. However, this doesn’t mean the portfolio will benefit from positive returns. The higher the probability of success, the lower payout; risk/reward. A portfolio with a 65% probability of success would have a much greater chance of realizing a net profit than a portfolio with a 99% probability of success. The balance between risk and reward is the difference between a profitable trader and a non profitable trader.
Traders use option greeks to measure the different factors that affect the price of an option contract. Delta is the most commonly used greek, and the most valuable. It tracks the theoretical rate of change of an option’s price, given a $1.00 increase in the underlying’s price. Strategies that are bullish will have a positive delta. Strategies that are bearish will have a negative delta. Delta also serves as the share equivalency of a position, directional exposure, and also can be used to determine the probability of an option expiring in the money (ITM), or the probability of touch (POT)
Share equivalency is the theoretical value of a position. If a trader sells one out of the money (OTM) put in SPY (S&P500 Index ETF) it may show a positive delta of 20, for this example. This means theoretically the position is equivalent to being long 20 shares in SPY. Each share of stock is 1 delta, so 100 shares of stock would equal 100 positive deltas. Each $1.00 the underlying moves up would result in a gain of $100. A trader may use delta as a tool to reduce their position size.
Directional exposure lets a trader know if their portfolio is bullish or bearish on the overall market, or an individual position. For example, if a trader is bullish on bonds and sells a put in TLT (Bond ETF) it would carry a negative delta beta weighted to SPY(S&P500 Index ETF) because the s&P500 has a negative correlation to the bond markets. However, the individual position would carry positive delta relative to itself, because the position is bullish on bonds.
The probability of expiring (OTM) is the probability an option expires worthless. As option sellers this is a good thing. This allows for a trader to create probabilistic outcomes. If the trader wants a 65% probability of profit on a trade, selling the 35 OTM delta would create such probability. But beware the 35 delta has a 70% chance of touch, or a 70% chance the stock breaches the strike price.
In statistics, standard deviation is a unit of measurement that quantifies certain outcomes relative to the average outcome. A one standard deviation encompasses approximately 68.2% of outcomes in a distribution of occurrences. Two standard deviations encompasses approximately 95.4% of outcomes, and three standard deviations encompass 99.7% of outcomes in a distribution of occurrences. The standard deviation of a particular stock can be quantified by examining the implied volatility of the stock’s options. The implied volatility of a stock is synonymous with a one standard deviation range in that stock.
For example, if a $100 stock is trading with a 20% implied volatility, the standard deviation ranges are:
- Between $80 and $120 for 1 standard deviation
- Between $60 and $140 for 2 standard deviations
- Between $40 and $160 for 3 standard deviations
From this, we can conclude that market participants are pricing in a:
- 68% probability of the stock closing between $80 and $120 a year from now
- 95% probability of the stock closing between $60 and $140 a year from now
- 99.7% probability of the stock closing between $40 and $160 a year from now
How do we capture all of this with options trading? We just need to remember a few probabilities in our strike prices:
- Strikes with a probability of 16% ITM / 84% OTM capture a 1 standard deviation range for an OTM option
- Strikes with a probability of 2.5% ITM / 97.5% OTM capture a 2 standard deviation range for an OTM option
Implied volatility can be used to calculate an expected range of an underlying for anytime period. A 19% implied volatility represents a 1% move in an underlying on that day; a $100 stock with a 19% IV would move +,- $1 that day. An underlying with an IV of 25% on a $200 stock would represent a one standard deviation range of $50 over the next year.
Option trading is purely through mathematical equations and statistical probabilities to create probabilistic outcomes. I never look at a chart, I never read an annual report, and I don’t care whatsoever what the media says, I trade purely off of the probabilities. Financial media outlets don’t talk about this stuff because they believe it’s too hard for the individual investor to digest. The only way to create a consistent return in the market is through quantitative finance. No fundamental analysis or chart is going to increase your probability of success. Trade small and create the most occurrences in the market place to have proof of concept. Let the probabilities play out.
