Probability of Success in Spreads

Discussion in 'Options' started by smile, Mar 29, 2013.

  1. smile


    Tom Sosnoff on Tastytrade here talks about Probability of Success in Spreads starting at about 11:00 minutes :

    Probability of Success in Spreads=

    Max Loss/Strike Width

    Max Loss is defined as:

    Debit paid or Strike Width-credit received.

    This is based on "efficient market theory".

    I don't buy this at all. What do you think?
  2. 1) What's your "hang up" about it? Think of it only as a hypothetical calculation. :confused:
    2) In the example from the video of paying $0.55 for a $14/$15 debit-spread, the probability of "success" is 55%, derived from the Max Loss of $0.55 divided by the Strike width of $1.00, which produces $0.55/$1.00, which equals 55%. :)
    3) Another way to look at is that since the debit paid was $0.55, it's extremely likely that the trade was initiated when the underlying was trading "somewhat" above $14.50, the mid-point of the strike prices. If the underlying remains stagnant through expiration, the $14-call will converge to intrinsic value, (i.e. $0.50 + "somewhat") and the $15-call will decay to zero, producing a spread value at expiration of $0.55 or better, confirming the 55% expectation of a profitable trade. :cool: .......(I think? :confused: )
    4) The higher the in-the-moneyness with respect to the strike price mid-point, the higher the likelihood of the spread being profitable. :D
  3. The same 'efficient market' theory would say that because the option market makers price options at max efficiency, over the long run you can't make any money on options.

    So from this I assume that Tastytrade is of the opinion that you can only make money by selling options, not by buying them.

    Well... a lot of people have that same opinion and that is nothing new.

    Their formulas are just attempts to back calculate where the option market makers THINK the market is going and what the MM's THINK the probability of going there is based on option prices. This would assume that option prices are solely set by the MM's.

    The part that is left out is that the market is much larger than just the market makers and that retail and institutional traders can make option prices 'inefficient' (in a statistical sense) by their buying and selling options beyond what the market makers compute from stats.

    Plus, of course, unpredictable events can make the option prices computed from stats meaningless.

    If the market, based on events, thinks the stock will go up or down, option buyers can move option prices in tune with that belief thus violating the statistical basis on which the market makers are predicting future price distribution. i.e. do the MM's just compute option prices based on the option pricing stats and formulas or do they also read the paper every morning?

    BTW that guy looks like an AH with that hat and the hair... is that some kind of a costume?? I thought it was a joke when I first saw him. Actually he looks just like the guy behind the counter in the pizza place around the corner from my house. I don't even like buying a pizza from him, much less taking market advice.

    The site should get somebody who doesn't look like a stumble-bum to front end it.

  4. It's true! And it's why you can replicate a digital with a vanilla vertical.
  5. 1) You're "new" to all of this, aren't you? :D
    2) That "AH" is worth more than you'll ever be in 100 lifetimes. :cool:
  6. If it is predicated on the efficient market hypothesis, I would take it with a pinch of salt.
  7. You need to add standard deviation for an accurate measurement.
  8. Delta can give you a rough idea of probability. For a more quantitative answer, use this formula (assuming a normal return distribution with no skew or kurtosis)

    X = exp(sigma*t*x)*S


    X = future spot
    sigma = percent volatility
    t = sqrt(days 'til expiry/365)
    x = standard deviations
    S = current spot

    the current price is 400.00, I want a 90% probability of finishing below a future price in 21 calendar days. My volatility estimation is 10%.

    X = exp(0.1*sqrt(21/365)*1.282)*400.00 = 412.5

    Likewise, I want a 90% probability of finishing above a future price in 21 days.

    X = exp(0.1*sqrt(21/365)*-1.282)*400.00 = 387.9

    The brighter folks can figure out the probability of finishing between 412.5 and 387.9.

    To find a given probability of your choosing, in Excel, use =normsdist(<your standard deviations here>).

    =normsdist(1.282) = 0.9
    =normsdist(-1.282) = 0.1

    The normsdist function calculates the area under the bell curve to the left of a given standard deviation value. Also, you can use 252 trading days instead of 365 calendar days if you prefer.

    How to trade this? Perhaps sell a 415 call, or sell a 385 put, or sell the strangle. Perhaps don't even use this technique, because assuming a perfect normal distribution will cause you to get your head handed to you eventually (picking up pennies in front of a steamroller.)
  9. jackblack


    Tom Sosnoff has made all of his 75 plus million by making a trading platform and selling a brokerage 'thinkorswim' to TD Ameritrade. He DID NOT make the 75million from TRADING stocks/options/futures.

    His 'System' has been in place for about a year and a half maybe a little longer?

    His math doesn't small trade often only increases commissions for tos or td. Some of the things he says does have merit. Eventually you will lose and wipe out the small gains you have made unless you cut losses early and NOT take a max loss...which from what i have heard sounds like his strategy. Managing 50% winners at 68% 'success' doesn't work when you take a max loss of 32%, even with a vol contraction, giving you an edge of 2%.

    to find out why this doesn't work you can do simple math and calculate max win * percentage =x. take max loss * percentage=y. add y (negative number) to x (positive number). do you have a positive number. probably not.
  10. kicker81


    Tom Sosnoff is a flour trader at CBOE for about years and years before he began to built ToS.
    #10     Jan 21, 2014