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Why Probability Based Trading Is Not Working... Part
I: Credit Spreads
We’ve all heard: “If you
set Probability and Expected Profit/Loss high in your trading, you will
profit.” You were also likely told that this type of trading will
mirror the
casino business strategy, and, as everybody knows, this is a profitable
model… So then why are most traders that use probability based trading losing money? Does it mean that statistics are not working? Absolutely not! Statistics work just as well as a casino business model. What is not working is how you are applying the math to your trading. What
are most traders using
when trying to calculate probability of success? They are using a
one-size-fit-all
formula of Theoretical Probability that assumes Normal distribution and
volatility equate to implied volatility. Are these assumptions
right? In most
cases they are not.
Individual underlying assets could have a historical distribution that
does not
resemble the normal distribution, and an implied volatility that is
reflecting the
market view could also be inaccurate.
To overcome the common
challenges, consider the new methodology of probability calculation and
also an
introduction of two new Probabilities: 1. Historical
Probability Takes
into consideration the specificity of each underlying historical
behavior 2. Stress
Test Probability Uses
magnitude of the historical moves and represents the capability of the
underlying to perform certain moves without taking into consideration
direction
of that move This methodology allows
using specificity
of each underlying asset. Like one medical doctor said:
“You have to treat patients based on their personal medical history and
not on
an average temperature in the hospital…” To prove this point we used
Ez Trade Builder – a product that allows you to select a day in a
history and
then search through different option strategies, using Probability as
filtering
criteria.
Image A: Report courtesy of EzTrade
Builder - Product of EzTrade, Inc. As can be seen from the
table (Image A) Theoretical probability of profit (“Prob Profit”) for
these
trades is greater than 77%. This is not a bad probability to consider
for a
trade… But the results are disastrous! Eight out of ten trades are at
significant losses. Could these results seed
doubts of the validity of using Normal Distribution and Implied
Volatility in
Probability calculations? Absolutely. Image B: Report courtesy of EzTrade
Builder - Product of EzTrade, Inc.
View full report here Take a look at the two
columns on this report (Image B): 1.
Best Profit/Loss
– Results depict the best exit. These results have a low likelihood of
being
achievable… But provide a benchmark for understanding trade management. 2.
Last Day Profit/Loss – Results
depict the easy exit.
These results are the ones that traders can achieve by setting the
trade and
“do nothing” till expiration. The yellow row represents
summary results for the analyzing period. In our example,
if you wait till expiration, results would be a loss of $40,189. Not
good… It is a loss of almost your whole initial account of $50,000. Why did this happen? Scroll
to row 8 using the full report.
The full report will allow you to see much more information, plus you
can repeat
the analysis for other trades on this report. You can see that this
trade is a loss of $3,300. Let’s investigate this trade further. Click
on
symbol FCX and you will see the Detail Report. Image C: Report courtesy of EzTrade
Builder - Product of EzTrade, Inc. As can be seen from the above
table (Image C), theoretical probability is 81.89%. I think if someone
offered
you to get into the trade that has almost 82% of success; most traders
would
take it… and lose $3,300. Why? Take a look at Stress Test
(ST) probabilities, calculated based on FCX 1 Year – 5 Years history.
They are
around 40%, which is even less than the probability of guessing heads
or tails.
Now, with this new information about probability of success for this
trade,
would you still consider taking it? Let’s drill further and
try to understand what has happened. Scroll down on the Detail Report
and take
a look at Volatility table. Image D: Report courtesy of EzTrade
Builder - Product of EzTrade, Inc. Implied Volatility
percentile is very low - only 12%. This means the market anticipates
this stock
will not move a lot in a near future. This also reflects on the
superficially
high theoretical probability. Results – market “wisdom”
is wrong, the stock moved 15 points and the trade lost over $3000. If
you do a
similar analysis of the losing trades on this report, you will see how
important is to watch the Stress Test probability. When you are analyzing the
trade - you want to “Stress Test” it. In other words, find out what is
the
probability of success, if the stock moves against you. This approach of
calculating the Stress Test probability gives you the opportunity to
avoid
costly mistakes. Finally I want to look at
the Put Credit Spread Track Record
Report
where filtering parameters are set the way that allows
you to take advantage of Stress Test probability over Theoretical
probability. This
report lists the trades for the period from 2008 till September
expiration of
2013. Now take a look at the results for 2011, you will find a profit
of almost
$28,000. Compare this with the loss of $40,000 in our previous Track
Record Report
and you will see the power of using Stress Test probability.
Continue reading
Part II - Short Puts. |