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Why
Probability Based Trading Is Not Working... Part II: Short Puts In
Part I we used Credit
Spreads to demonstrate why most of the traders who incorporate
Probability
Based Trading into their trading are losing money.
Those who have not read Part I can click
here. In Part II instead of
Credit Spreads we will analyze Short Puts to demonstrate that problems
with Probability
Based Trading are not related to a certain option strategy. They arise
from the
common assumption that historical behavior of the underlying can be
characterized
by the normal distribution and implied volatility. So let’s cut to the point
and show the results of the search through the universe of possible
Short Puts on
a selected trading date. Our filtering criteria would be similar to the
ones
that were used in Part I  Theoretical Probability to be high and at
the same
time greater than Stress Test Probability.
Image A: Report courtesy of EzTrade
Builder  Product of EzTrade, Inc. As can be seen from this
table (Image A) the Probability of Profit that is calculated based on
the assumption
of a Normal Distribution and volatility equated to the implied
volatility, is extremely
high  over 85%. Most traders would certainly take a trade with such
probability… And in 6 out of 10 cases would lose a substantial amount
of money… To understand why this is
happening let’s take a look at the historical behavior of BGC (General
Cable
Corp…)
Image B:
Chart courtesy of EzTrade
Builder  Product of EzTrade, Inc.
The
red line on the top pane of this chart (Image B) represents the normal
distribution
“Bell Curve.” The green bars represent statistical occurrences of the
historical moves of the underlying asset. As it can be clearly seen the
real
historical distribution of this stock does not even closely resemble
normal
distribution. Further
analysis of the Theoretical Probability vs. Stress Test Probability,
can be
done using Probability table (Image C.) Image C: Report courtesy of EzTrade
Builder  Product of EzTrade, Inc. This table demonstrates that the Stress Test (ST) probabilities, calculated based on real 1 Year  5 Year histories of the stock, equate to almost half of the Theoretical probability. What is this information telling or should I say “screaming” to the trader? This information is an indication that Stress Test analysis of real historical behavior of BGC gives you less than a 50% probability of the trade being profitable. You should consider additional review of trades that have such discrepancies in probabilities, unless there are facts (news, change of fundamentals etc.) that override previous historical behavior. We know that two major assumptions in calculation of commonly used OneSizeFitsAll formula for Theoretical probability are: normal distribution of underlying asset and volatility equated to implied volatility. We have already demonstrated that historical distribution of BGC does not resemble the normal distribution. Now let’s take a look at implied volatility. Image D: Report courtesy of EzTrade
Builder  Product of EzTrade, Inc. The
absolute value of implied volatility doesn’t tell you much, but
percentile or a
comparison of the current value to its historical values can give you a
clue… Such
a low implied volatility percentile can indicate that the market does
not anticipate
a big move in the near future. On the other hand our historical
analysis
indicates that this stock is capable of big moves. Can
you always rely on market “wisdom” and make your trading based on it?
Absolutely not… If the market view is always right then there would be
no
reason to trade options at all, as you would constantly be on the
losing side. Only
the ability to beat the market makes trading profitable. Now
let’s take a look at the daybyday behavior of this trade from its
inception
to expiration and find out whose prediction on volatility and potential
moves
were right.
Image E:
Chart courtesy of EzTrade
Builder  Product of EzTrade, Inc. On this chart (Image E),
the top pane shows closing price (blue line) and selling strike
(horizontal red
line.) The bottom pane shows daily
option prices (red line) and profit/loss values (green line.) As can be seen during the
trade, the stock
dropped in price from over $41 to less than $26. This significant drop of around 40% was not anticipated by the market, but was predicted by our Stress Test Analysis. The main outcome  use of the OneSizeFitsAll formula to calculate probability of success could result in a big and costly failure. The result of the BGC trade is not an
example of an insulated
occurrence. Take a look at the Track
Record Report
for Short Put strategy. This report allows for the viewing of trade
signals generated
by filtering criteria during a one year period. As part of the
filtering
criteria Theoretical Probability was set greater than Stress Test
Probability. The result is a loss of
$55,798. The reason why the loss exceeds the initial account of $50,000
is that
buying power for each trade is calculated based on “Best Exit” and not
for “Exit
on Expiration.” In this report, we tried to show all trades that
potentially
could have been taken if selection was based on tested filtering
criteria. BGC
was one of the trades that the Track
Record Report generates
(line 113), but not the only one that cause substantial loses. To get more confirmations
on the fact that historical behavior of the underlying in many cases
can’t be described
by normal distribution and implied volatility, one can use Track
Record Report
to perform the similar analysis and view the Detail Report for
particular stock.
By working through this Track
Record Report one
can argue that 70% of the trades that have similar conditions as BGC
end up
profitable. That is true… But you always have to remember that even
100% probability
does not guarantee an event happening. Probability describes only
likelihood of
the event. Ability to quantify your
risk and make calculated decisions forces traders to use probability
based
trading. It does not preclude them from losses, but allows selecting
probability based on the traders risk tolerance. Stress test analysis
provides
effective management of expectations and substantially improves final
results. To prove this take a look
at the Track
Record Report,
where filtering parameters are set to take advantage of Stress Test
Probability.
This report gives an overview of all trades from 2008 till September
2013. If
you scroll through the report to find the summary line for year 2011
(green row
between line 346 and 347), you will see that profit with “Exit on
Expiration”
is $77,424. Compare this to losses of $55,798 and the advantages of
using
Stress Test Probability will speak clear and loud!
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