Options Trading: Bet heads on a coin with one tail and two heads
This is not “The Matrix” but it’s totally possible. Trust me.
Not only you can flip a coin betting heads and making it so that is has three sides, two of which are heads- but you can also make that coin flip move so slow that even the tails side, over time, starts vanishing and converting itself into George Washington’s face.
Like when Marty McFly punches Biff Tannen in the face back in the 1950’s, and the headlines of disaster in a newspaper, start changing into wonderful things for him and his family.
And if the transformation doesn’t happen, you could press the “repeat” button, with little cost, giving you yet another chance to flip and be right on your bet.
Also, if the bet was really small, you could do this several times more until it was almost like turning back time and calling off the bet, putting the money you had at risk back into your pocket.
Totally unfair, but that’s what we need in order to win at investing- putting the odds on our side.
Meet your new friend, the stock price probability curve
What does this curve (2) show?
It shows the probability of the price of SPY stock being on a specific level. The taller it is in any such level, the highest probability it has to land there.
In every case, for the present time, the most probable level is the current price (1) in this case $226.70. It makes sense because there has to be some kind of effort in order for things to move in stocks and in physics (like flipping the coin) or else things will just stay there where they are.
The parallel vertical lines that you see cutting the probability curve indicate common probability levels that are important in science: 1 and 2 Standard Deviations (SD). 1SD represents about 68% of success rate and 2SD represents about 95% success rate.
If 1SD is 68%, that’s slightly better than having a coin with two heads and one tail, for when we bet heads, we will have a 2/3 probability of winning (66%).
But keep reading, there’s even more factors that put odds in your favor!
Where do the probabilities come from?
They are implied, that is given the options market prices, through mathematical formulas, you can deduce how much the market thinks a stock is going to move either up or down and how probable it its it will reach such extremes or ranges.
So why is it important to look at this curve when investing?
If you want to have a higher probability of success with your trades, the more you paint this curve with the trades you put on in green color, the better.
The trade-off is that you will get paid less the higher probability of success, like when you bet on a favorite horse or sports team to win an event.
But you don’t necessarily need to paint it all green to be successful according to Tastytrade studies.
Market makers are institutions that both provide buying and selling points for retail investors. Think of them as “wholesale dealers” of financial instruments.
They usually take the 1SD level (68% of probability) as good enough for estimating the actual real move and generating prices for retail customers. They buy low, sell high and do that for a business constantly.
If its good enough for them, it has to be for retail investors who want to sell options too. Why?
Once again, Tastytrade studies show that 83% of the time price will fall in that range because as we saw before, volatility relative to itself is overstated (link)
So does this mean that the probabilities that the market assign to the move are wrong?
The probabilities in future events for social sciences are expectations, they are not right or wrong but rather a function of human nature.
Since we fear the unknown and want protection or fantasize about it like when buying penny stocks thinking we are going to earn millions with them (“Bitcoin is going to the moon!”), studies show we tend to overpay for these events.
But in reality nobody knows what the future holds and that’s when scientific data and statistical studies come to the rescue, helping us distinguish imaginary fears and fantastic ideals from the most probable form of reality.
In following articles I’m going to talk more about the other two factors that put odds on your side: how the coin can be slowed down in mid-air and help you change history and if it doesn’t work, how to repeat the flip with little cost.
Originally published at MyTraderJourney.com.