Tradespoon provides you with different tools to calculate risk. Probability Calculator is one such tool. It helps determine the risk by showing you the Short-Term Support and Resistance levels. It also shows the probability of a stock reaching a certain price point by the expiration date. Probability Calculator is very important for both stock and options traders, as it gives you a statistical analysis of the stock being at a certain price point.
One standard deviation in the Probability Calculator (PC) is really basic statistics. When trading options, you will often hear that you are looking for 30% gain between the strike prices of a spread, or whatever strategy you are executing. You usually want 30% gain between the strike prices, which means you are looking for roughly 68% chance of being correct. Basic statistics is very important if you want to know the odds of the trade in order to be successful.
Historical vs. Implied volatility
Two other tools are Historical Volatility and Implied Volatility. Historical Volatility shows how the stock has behaved in the past and how volatile the stock has been over previous time frames like 20, 30, or 100 days. Historical Volatility is a measure of the volatility of the underlying. It can be thought of as the speed or rate of change of the underlying stock price or how often does the stock price change. The higher the Historical Volatility, the higher the rate of change and hence the more the risk involved with the underlying asset.
Implied Volatility predicts what the future performance of the underlying stock is going to be and can be used to predict where the Stock is going to be in future. Implied volatility is a function of an option price and is backed out from the price using a model or calculator. Implied Volatility shows you the expectations of future volatility and can be thought of as the uncertainty of the underlying asset. You can use different models, such as binomial model or binomial equation, to predict Implied Volatility based on premiums. You can also look at dividends and other attributes such as the interest rate.
As you approach earnings, Implied Volatility will expand due to the future expectation of what will happen to the underlying asset. In order to be a successful trader you have to study movements of Implied Volatility and learn how it changes between the earning seasons or between different binary events. You can see both Historical Volatility and Implied Volatility in Figure 9A.
The most important concept that Tradespoon advocates on every trade recommendation is this: Higher return on capital means higher risk! By using the Probability Calculator, you can structure your trade accurately 80% of the time and you can be right 90% of the time by selling the out-of-the-money options. But this comes at the price of taking High Return on Capital. You have to be very aggressive in defending your position and in making sure that the trade doesn’t go against you.
The Probability Calculator will show you the probability calculated of models and predicts stock prices based on the Options Expiration Cycle, which is very important to options traders. Probability Calculator will show Support and Resistance prediction for the next 50 days. If you are a weekly trader, you will be shown the Support and Resistance for the next 5 or 10 days. It will also show a Trend value, and a Buy/Sell Rating, which shows the probability of the stocks being higher or lower and how predictable the stock behavior is based on our neural network analysis.
In Figure 9B, the probability of DOW being higher than $54.54 is only 11.9 %, which means roughly 11% of the time you will be correct if you buy 55 strike call. This is not the best strategy if you are bullish on DOW. You might be better off by paying more and buying 45 call option because there is a 71.64% probability of Dow Chemical being between 47.16 and 54.54 in the next 50 days. Also, you want to compare the Historical Volatility for the past 50 days with the Implied Volatility of the future and see if there is a discrepancy and what is happening in the underlying asset.
When a certain event happens, you tend to do it over and over again, like rolling two dices in which there is a higher probability of landing a 5, 7 or an 8. In the same way, if you trade options over and over again, the 1 standard deviation of the stock being between certain points will be higher.
1 Standard Deviation for options helps determine Support and Resistance of the underlying stock based on Implied Volatility or Historical Volatility. 1 Standard Deviation can be defined as having a 68% probability of the stock reaching Strike Price (µ) by a certain date. So, (µ-1) is 1 Standard Deviation. (µ-2) is 2 standard deviations and, which means 95% of the time stock will be between the two key Price Points. Bollinger Bands is another technical indicator that you can use to make this prediction.