Probability Concepts For Iron Condors

  
     
  By Donald Scott
  
   
     
  Hi option traders. I hope you're having a great day. In this article I want to discuss standard deviations and probabilities as they are calculated by the popular options analytical software that is on the market. In the video that is attached to this article we are using software by Think or Swim. This is one of the most popular software programs in the world. It has a built-in feature to help us calculate probability of complex option strategies, but there is one thing missing when we use this feature. The software does not consider the current trend of the underlying that is being analyzed. Instead, the software always assumes that the underlying is trending sideways.


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?

I've constructed a typical Condor in this video which is hopefully attached to this article. If it's not, then please visit Youtube.com/sjoptions. It's just 30 days out and I'm selling a 10 Delta, and I used a 10 point spread. This is a very common trade, and I'm not recommending this trade or anything like that. I don't do this type of trade myself. What I want to illustrate is that maybe the probability isn't as high as we think it is. In the video we are assuming that the software is calculating probability correctly, but in fact the software doesn't know the current trend in the underlying. The software shows this trade has a probability of 79%, but in reality that's only if the underlying is going sideways. 99% of your option traders assume this is the correct probability on this trade. But when they're making this calculation, they are completely throwing out technical analysis.

For example, if rain drops are falling from the sky, and they land on a flat and level surface, then the software is correct. However, if the rain drops land on a hill, then there's a higher probability that they'll splash downhill than uphill. Those of you that have traded stock and options for a while know how technical analysis works, and you'd agree that if the market is in a down trend, and if the software is analyzing for a sideways trend, then the probability calculation will be wrong. Look at the graph in the video and you'll see that the probability realistically is about 45% and not 79% as it appears to be. This is just an estimate but you get the idea.

Every experienced trader knows that the market normally trends in a direction, making the probability of the Iron Condor not as high as we believe. Those of us who believe in technical analysis should find a way to calculate probability using the trend combined with standard deviations. This would give us a more accurate analysis of the trade. As a final example, a bearish trade will actually have a higher probability in a bearish market than it appears to have in the options analytical software.

I will finish by saying that maybe we should really ask the question: what factors should we include in our calculation when we analyze the probability of an option trade? Should we throw technical analysis out the window and always assume that there is an equal chance for the stock market to go up or down at any given time? When it rains, how often do rain drops land on a perfectly flat and level surface? Do they ever?



  
   
  Article Source: http://interpret.zar.vg   
     
  About The Author
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