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Probability come formula in function of IV
- Thread starter OrthoSurg
- Start date
LightngMcQueen
Aspirationally Rational
I can not help you with an exact formula but I can help you draw and intuit the curve based on (my) understanding of IV and std distribution.
1. 70% probability is equivalent to +/- 1 std deviation from the current share price (68% to be exact).
2. Std deviation dollar value is stock price * IV (this is from definition of IV itself).
3. Because IV is yearly std dev expressed as percentage of stock price that is how wide the cone will be a year from now. You need to draw it back / scale it down for shorter time period.
Example
Lets take Oct 15 700P with IV 45% as of Friday close (https://www.nasdaq.com/market-activ...-chain/call-put-options/tsla--211015p00700000). Assuming SP of $750 for ease of calculation:
This gives us std dev of $750*.45 ~= $350 ($337 to be exact)
This means that market prices 70% probability that SP will be between $400 and $1100 - a year from now (Sep 2022). So 70% cone will stretch from $400-$1100 year from now.
Few caveats
1. I do not really know what I am talking about ... I do it for sports and seem to be lucky
2. Stock movements do not have normal distribution, tail events are more frequent than Bell Curve would predict, Nassim Taleb explained it in one of his books, but I forgot which one.
If SP would track normal distribution well then the IV value would be constant across different strike prices and expiration times, in fact IV values differ quite a bit. High IV for unprobable, OOM strike prices is the way the market accounts for distribution not being normal and Black Swans happening much more often than Gaussian distribution would predict. For example Oct 15 $100 P has IV of 200% !
IBKR has probability lab Probability Lab | Interactive Brokers LLC ( link in bottom of the page)
it can draw the curve for you. I find it frustrating slow to use though.
Given the caveat #2 I do not usually find it worth my time unless I make a really concentrated bet, which I rarely do.
1. 70% probability is equivalent to +/- 1 std deviation from the current share price (68% to be exact).
2. Std deviation dollar value is stock price * IV (this is from definition of IV itself).
3. Because IV is yearly std dev expressed as percentage of stock price that is how wide the cone will be a year from now. You need to draw it back / scale it down for shorter time period.
Example
Lets take Oct 15 700P with IV 45% as of Friday close (https://www.nasdaq.com/market-activ...-chain/call-put-options/tsla--211015p00700000). Assuming SP of $750 for ease of calculation:
This gives us std dev of $750*.45 ~= $350 ($337 to be exact)
This means that market prices 70% probability that SP will be between $400 and $1100 - a year from now (Sep 2022). So 70% cone will stretch from $400-$1100 year from now.
Few caveats
1. I do not really know what I am talking about ... I do it for sports and seem to be lucky
2. Stock movements do not have normal distribution, tail events are more frequent than Bell Curve would predict, Nassim Taleb explained it in one of his books, but I forgot which one.
If SP would track normal distribution well then the IV value would be constant across different strike prices and expiration times, in fact IV values differ quite a bit. High IV for unprobable, OOM strike prices is the way the market accounts for distribution not being normal and Black Swans happening much more often than Gaussian distribution would predict. For example Oct 15 $100 P has IV of 200% !
IBKR has probability lab Probability Lab | Interactive Brokers LLC ( link in bottom of the page)
it can draw the curve for you. I find it frustrating slow to use though.
Given the caveat #2 I do not usually find it worth my time unless I make a really concentrated bet, which I rarely do.
Last edited:
LightngMcQueen
Aspirationally Rational
I have found that to quickly convert yearly IV to shorter values
In the nutshell from above article… if IV represents maximum yearly move with 70% confidence then monthly move with 70% confidence is 3.5 smaller and daily move is 16 times smaller.
So in example above 70% confidence cone is +/-$350 wide a year from now, +/- $100 wide a month from now and +/- $22 wide for one day.
In the nutshell from above article… if IV represents maximum yearly move with 70% confidence then monthly move with 70% confidence is 3.5 smaller and daily move is 16 times smaller.
So in example above 70% confidence cone is +/-$350 wide a year from now, +/- $100 wide a month from now and +/- $22 wide for one day.
Love that explanation, it makes it really easy to evaluate it quickly.
thanks for the info, really helpful!
LightngMcQueen
Aspirationally Rational
NP
Keep in mind that I am not what you would call an expert. Your question forced me to consolidate and write down my understanding so it was helpful.
I've realized after writing above answer that given the extra information from the quoted article the cone formula you have originally asked for is easy to complete.
Given Share Price SP, implied volatility IV and day number d from today would be:
Upper bound: SP + ( SP * IV * sqrt( d/365) )
Lower bound: SP - ( SP * IV * sqrt( d/365) )
Keep in mind that I am not what you would call an expert
. Your question forced me to consolidate and write down my understanding so it was helpful. I've realized after writing above answer that given the extra information from the quoted article the cone formula you have originally asked for is easy to complete.
Given Share Price SP, implied volatility IV and day number d from today would be:
Upper bound: SP + ( SP * IV * sqrt( d/365) )
Lower bound: SP - ( SP * IV * sqrt( d/365) )
Well you have trading experience so you are more an expert than I am with my 20 hours of Option Alpha Online course. I’m still trying to understand how to set up a strategy to have a 70% chance of success based on Implied Volatility.
Really interesting stuff but the strategies are more complicated than just YOLO all our portfolio on out of the money calls like they do on wallstreetbets. Less chance to lose it all with 1% Iron Condors
Really interesting stuff but the strategies are more complicated than just YOLO all our portfolio on out of the money calls like they do on wallstreetbets. Less chance to lose it all with 1% Iron Condors
LightngMcQueen
Aspirationally Rational
My take is that “trade with X (70%) probability of success” based on the option metrics is looking at it from wrong side.
This 70% probability is already fully priced in, that’s how we know it after all … it is inferred from the option price.
Not only that … you incur the extra cost of transaction.
So in reality you are paying ~72cents for a ticket with 70% chance of winning a loonie ($1). Technically ~70% chance of success but in practice guaranteed loss if you keep doing it.
IMO money is made when market misprices probability… for example market prices 15% probability that Tesla is below $400 in Sep 22 and say you think that odds are more like 5% … you may chose to sell PUT spread and you expect to be right 2/3 of the time
This 70% probability is already fully priced in, that’s how we know it after all … it is inferred from the option price.
Not only that … you incur the extra cost of transaction.
So in reality you are paying ~72cents for a ticket with 70% chance of winning a loonie ($1). Technically ~70% chance of success but in practice guaranteed loss if you keep doing it.
IMO money is made when market misprices probability… for example market prices 15% probability that Tesla is below $400 in Sep 22 and say you think that odds are more like 5% … you may chose to sell PUT spread and you expect to be right 2/3 of the time
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