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  1. Implement Probability Arbitrage – New approach to option trading

    • Probability Xtreme Play Before Earnings
    • Probability Xtreme Play After Earnings

  2. Identify Volatility Xtreme situations

Probability based Trading Ideas

Trade Ideas are based on Probability Arbitrage. A metod that takes into consideration discrepancies between Theoretical Probability that most market participants use today and Historical and Stress Test Probabilities.

The best way to think about Probability Arbitrage is in the form of the following analogy:

Two travelers are walking barefooted in a jungle. Suddenly, they see a tiger running toward them. At this point, one of them takes his running shoes and starts throwing them on. The second asks him, “Why bother? You really think that wearing sneakers will help you run faster than a tiger?” The other traveler calmly replies, “No, but all I need to do is run faster than you!”

 Now if you think about it… This is the epitome of option trading.

In option trading, you always have somebody on the other side of the trade. If you’re buying options, somebody has to sell them to you. If you’re selling options, somebody has to buy them from you.

So in order to be profitable, you don’t have to beat the market or “outrun a tiger.” What you have to do is beat your opponent on the other side of the trade.

Stratagy Analysis

The introduction of Historical and Stress Test probabilities as well as a new methodology in calculating Estimated Profit/Loss substantially improves strategy analysis and provides a better assessment of the risk associated with the selected trade. Read more on the importance of Estimated Profit/Loss as a measurement of Risk/Reward here.

Chart depicts comparison of Theoretical probability calculated based on normal distribution and real historical distribution of the underlying asset.

Theoretically the historical distribution of the underlying can be compared to the normal distribution; however, the probability distribution chart above shows that once you start looking into individual stocks, this assumption doesn't hold true.

It’s pretty much the same as going to the Hospital and your doctor treats you based on the average temperature of his patients and not based on your personal medical history.

Would you be happy with such a treatment? Doubt it.

So why accept a “one-size-fit-all” formula for calculating Probability? Why not pay more attention to the individual behavior of the underlying?

To answer these questions we developed Probability Arbitrage - Smarter Way of Options Trading click here to read more...

When you use Probability Based Trading and rely on a “one-size-fits-all” formula, you may think you’re employing a sophisticated mathematical approach. In reality you are basing your calculations on incorrect assumptions that jeopardize your profit.

To overcome this two new probabilities were introduced:

  1. Historical, which takes into consideration the specificity of each underlying historical behavior
  2. Stress Test, which uses the magnitude of the historical movement without taking into consideration direction of that move

The purpose of Historical and Stress Test probabilities is straight forward:

  • Enhance our understanding of a real historical distribution of underlying
  • Move from what we called “ the average temperature of the patients” to what reflects individuality of the underlying.

Stress Test probability allows traders to better understand the behavior of the underlying asset from inside out. It can be described as a potential “spring” with the ability to move:

You have a spring that was squeezed from both directions. Now if you know that the spring will be released from the right side you can comfortably stand to the left. But if you do not know which end will be released you better stand a safe distance from both sides of the spring.

Let’s say you’re analyzing a bullish strategy, like Short Put or Put Credit Spread. If lately the stock has had some large moves in the up direction, the Historical probability for the bullish strategy would be high.

But since you know the stock has potential to make large moves, how can you be certain that once you enter the trade it won’t change direction? What if it performs the same large moves, but now against you? I bet you can relate to that. How many times in your trading career did a stock behave in one direction, and then as soon as you got into the trade, it reversed itself?

Hearing these stories, EzTrade introduced Stress Test probability. We did this because it reflects the probability of surviving, or ending up profitable in a trade when the underlying asset exhibits the worst case behavior and starts moving against you.

Stress Test probability warns you about what can be anticipated by getting into a trade. This allows you to see the probability from a different perspective, better comprehend the trade, and set proper expectations.

Price Trajectory and Stress Test Probability Charts

These are absolutely unique charts that you will not find in any other service.

Price Trajectory chart indicates price bands that the underlying asset will not exceed on a certain date based on 90% of Stress and Historical probabilities.

Using these charts allows you to determine the underlying assets price range expectation on a certain date and helps you to define a strike price when building or adjusting your trade.

Stress Test Probability charts depict the probability of not exceeding the selected price points on or anytime before expiration for your selected strategy.

Volatility Xtreme based Trading Ideas

     All stocks ranked by three types of ratings:

  1. Expensive / Cheap: This rating is based on Implied Volatility percentile, where high percentile indicates expensive options and has a rating of 1. Cheap options have a rating of 3 and indicate a low Implied Volatility percentile Read more about volatility percentile
  2. Overvalued / Undervalued: This rating represents comparison of Implied Volatility to Historical Volatility. One of the major components of the option pricing model is the volatility of the underlying asset. The higher the value of the volatility the higher the option price. By definition Implied Volatility represents volatility of the current option price. Historical volatility produces an option price that reflects historical behavior of the underlying asset. By comparing the Implied vs. Historical volatilities one can conclude if the current price is overvalued / undervalued compared to the historical movements of the underlying asset. The problem with this approach is to define how far into the history you have to look to calculate Historical volatility in order to compare it to Implied volatility and claim that the option price is over/under valued. Our service takes into consideration composition of different short and long term historical volatilities (5 Day, 10 Day, 20 Day, 50 Day and 100 Day) to define the rating.
  3. Historical Percentile: Composite rating of different short and long term historical volatilities percentiles

Volatility Analysis

Volatility based trading is the most commonly used method in analyzing option trades. Seasoned traders use various tools to perform volatility analysis with the expectation that this will give them a competitive advantage over the rest of the market.

Depict Volatility Percentile analysis that is crucial for realization how Cheap or Expensive options are. More on volatility percentile read here

Let’s first emphasize the difference between Historical and Implied Volatilities.

Historical Volatility is a measure of the historical movement of the underlying asset and can be seen as a reflection of the market participant’s view of the particular underlying asset.

Implied Volatility is a characteristic of an Option premium that reflects the option markets future expectations of the underlying asset’s movement. Implied Volatility is a completely different ‘animal.’ Even if both the implied and historical volatilities have a high correlation, they reflect two different points of view on the market and it is very important to understand this.

When these two groups of market participants have the same view on the underlying asset, the Historical and Implied volatilities are typically close. When their views are different, you can see discrepancies in volatilities.

Nobody has a crystal ball to see what will happen in the future. Neither group is always right. Your ability to compete against these groups is exactly what keeps the options market alive!

This is why traders are looking for Implied Volatility that is either low or high compared to its historic levels.

The reason for this is the so called “Rubber Band effect.” When Volatility reaches its extreme position there is a high probability that it will turn around and start moving in the opposite direction. This pattern or “Rule” of Volatility behavior is the driving force behind Volatility based trading.

Volatility traders believe at certain points Volatility behavior becomes more predictable than the behavior of the underlying asset.

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