Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Using option valuation and trade probabilities measures can provide ways to rank and qualify potential trades. The July article series has been focused on determining whether the Probability of Profit (PoP) trade measure can act as a secondary filter to an existing delta filter for an iron condor strategy. Unfortunately the series is more an exercise in the evaluation process rather than a final result.

Delta versus Probability of Profit

First, the strategy being evaluated is an index iron condor where credits are received for both the call spread (bearish) and the put spread (bullish) creating a profitable trade when the index moves sideways between the breakevens. In a single, long option position delta can be thought of as the probability the option will close in-the-money [ITM]. However, position profitability is not a consideration when using this approach because it simply looks at the option being ITM or out-of-the-money [OTM] at expiration.

A trader establishing a single, short position is interested in the probability the option will close OTM. By taking the inverse of delta, 100 – absolute value of delta as one approach, this probability is provided [corrected equation for 1 – delta]. Applying this to spreads, the sale of the lower valued option in a debit spread reduces the net absolute delta for the position reducing the probability the combined position will be in ITM at expiration. Again, the trader establishing a credit spread is net short and interested in the probability the combined position is OTM [1 – position delta].

PoP does incorporate premiums in the probability calculation, so net cost is considered along with moneyness of the position at expiration. In Optionetics Platinum the user can identify the volatility measure applied to the PoP calculation, so when starting the analysis implied volatility [IV] was used initially to reflect market expectations about future index movement rather than just calculating PoP considering historical movement.

Since this particular position is established with limited time to expiration (credit), it appeared that there was little difference between PoP values using IV and PoP values using the 20-day statistical volatility [SV]. This makes sense given the shortened time period and the fact that historical movement is generally incorporated into expectations about future movement. This is mentioned because the 20-day SV PoP was used in place of IV PoP here so larger data sets could be evaluated—it’s simply easier to obtain a daily series for this the SV when using the Platinum Backtest tool.

Although PoP may provide an alternate approach to the trade set-up, Odds may be a better choice since it incorporates probability of profit into the calculation, along with payouts. The remaining portion of this article is based on analysis of 9 iron condors over a three-month period using the Phlx Gold/Silver Index^SM (XAU). In addition to reviewing delta and odds for the iron condor, these measures were also reviewed for each separate leg in the position.

Charts

A variety of charts displaying XAU closes, Iron Condor closes, deltas and odds follow.

Figure 1: Iron Condor Leg Deltas versus XAU Close

In this highest profit trade, the distance between the two leg deltas seemed most consistent among all iron condors. In addition, the only delta volatility visible is near the end of the trade life for the call leg. This leg generated losses for the position even though a net gain was achieved.

Figure 2: Iron Condor Leg Odds versus XAU Close

The odds for put spread profitability jumped significantly as XAU moved moderately upward with less than half the original number of days to expiration.

Figure 3: Iron Condor Leg Odds Ratio (Put/Call Spread Odds) versus Condor Close – 1

Figure 3 provides similar data for the leg odds in the ratio form Put Spread Odds / Call Spread Odds. In the event the call leg was generating the bulk of the profits, we’d expected to see profits generated for small ratio values approaching 0 since the call spread odds are n the denominator.

Figure 4: Iron Condor Leg Odds Ratio (Put/Call Spread Odds) versus Condor Close – 2

The call portion of this iron condor was profitable, with the odds ratio becoming smaller and smaller as the numerator decreased and the denominator increased.

As mentioned, the end result of this series is more one of process than determining an exact measure to add to the trader’s current set-up. As the analysis progress though, it seems that some sort of normalized ratio for odds and/or a measure that considered the consistency of the delta spread for the two legs may add value to trade selection.

To see the other articles by this author, please click here.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Clare White, CMT, Optionetics.com

• November 13, 2008
  Analytical Toolbox: Market Outlook—Now What?
• November 6, 2008
  Platinum Tools: Reviewing Portfolio Charts
• October 21, 2008
  Option Watch: October 2—A “$@#!! Apple” For Bulls?
• October 2, 2008
  Platinum Tools: Using Tools as Market Conditions Vary
• September 25, 2008
  Analytical Toolbox: ROC Variation Correction