Platinum probability tools apply statistics to the underlying security’s past movement to provide expectations about the future. The tools use assumptions similar to those in option pricing models and the default settings can be changed. Before making changes, however, it’s best to start with the default settings provided in Platinum.
This article provides a view of the tools referencing a 2011 case study for Cisco Systems (CSCO). The strategy is an iron condor which benefits from an implied volatility [IV] crush that occurs near earnings for the stock. An iron condor combines a bear call spread and a bull put spread for a net credit and benefits from predominantly sideways price action.
As a review, option pricing models and the Platinum probability tools use these assumptions for the underlying security:
- Prices follow a lognormal distribution (returns follow a normal distribution)
- Volatility remains constant through expiration
- The mean return for the underlying through expiration is zero
Please see the Analytical Toolbox articles from 2/2/12 and 2/12/12 for more information on basic probabilities and these assumptions, or search “probability” in the site content.
Case Study
The description that follows focuses more on what information is being provided by the probability tools, rather than the strategy.
Figures 1 & 2 provide the strategy details and risk graph for the Nov-11 CSCO iron condor. The combined credit spreads included a Nov 20-19 bear call spread and a Nov 16-15 bull put spread with an upside breakeven of 19.27 and a downside breakeven of 15.73.
Figure 1 Nov-11 CSCO Iron Condor with Breakevens
The reward:risk profile for this strategy is not great (approximately 37%); however the trade-off is the high probability for the strategy.
Figure 2 Risk Profile for Nov-11 CSCO Iron Condor
Probability of Profit
Figure 3 provides probability table details. Keep in mind the assumptions are lognormal prices (check, will no longer discuss), constant volatility and a mean return of zero between now and expiration.
Figure 3 Probability Table for Nov-11 CSCO Iron Condor
Using my default settings the table assumes that the volatility of the underlying, the statistical volatility [SV] will remain constant through expiration. The actual value is 41.01, its 100-day SV. It also assumes CSCO will average a price of 17.61 through expiration, meaning it doesn’t have to close at this level—it simply has to average that price using closing values over the next seven trading days.
The probability of profit [PoP] for this strategy using the assumptions discussed above is approximately 88%. Pretty impressive, but a trader must ask, “to what extent do the assumptions match reality?” We can get clues on that by viewing other earning periods for CSCO.
Starting with the SV assumption, Figure 4 displays the 2-year SV for CSCO with a 6-day SV that generally lies between 10 & 40, but does seem to spike up post-earnings. Recently this spike was as high as 120, but more often ranges between 60 & 100.
Figure 4 Two Year SV Chart for CSCO
A view of a CSCO price chart with earnings markers shows it is common for a price gap to occur the day after earnings which transitions into a more moderate move in the same direction over the next couple of days. This exercise is left for the reader.
So an iron condor must accommodate a one day gap in price with some drift in the same direction. Although the 6-day SV remains elevated for a couple of days, it is really that one day move that impacts the calculation which uses 6-days worth of data. It isn’t until the 7th day post earnings that this price move will be dropped from the 6-day SV calculation.
When the SV calculation is changed to 80 to take into consideration increased volatility post earnings, the PoP remains at 58%. This remains impressive since we expect to have volatility significantly decline two days after earnings. If you were to only change the SV value for this case study, the most accurate reading for PoP will likely be generated using the 100-day SV two days post earnings which is two days into the strategy.
Probability Cone
The probability cones use the same model assumptions and display regions that represent:
- +/- 1 standard deviation moves for the underlying (red cone) and
- +/- 2 standard deviation moves for the underlying (blue cone).
Once again this assumes constant volatility which is used in the standard deviation [SD} calculation. The borders of the cone provide the underlying’s price path if a:
- +1 move occurred every day until expiration (upper red boundary curve) and
- -1 move occurred every day until expiration (lower red boundary curve).
Figure 5a displays the probability cone on the day of the case study. Note that since this is back-dated information, Platinum fills in the price action that has since taken place.
Figure 5a Probability Cone for CSCO Iron Condor—Day of Earnings
The notion of mean return = 0 is best viewed simply as price movement around the horizontal line at the current day’s close. More importantly, the trader can also view the breakeven levels for the strategy, which are shown as light blue horizontal lines between then red cone and the blue cone. This information is read as follows:
- "Assuming CSCO continues to behave over the next seven trading days as it has in the past 100-days, the strategy will be profitable even given +/- 1 SD moves each day."
This is seen as a red cone that is completely within the upper and lower breakeven levels and a strategy that relies on sideways movement to be profitable. In this case study the strategy was indeed profitable, but that is not our focus.
Figure 5a shows that the initial post-earnings move for CSCO was greater than a +2SD move up—price is above the upper boundary of the blue curve. A useful exercise for traders implementing the iron condor strategy when a short-term, moderate price gap is expected; is to view the probability cones the day the gap occurs or the following day to visualize the impact from the new price level.
Figure 5b displays the new probability cones view the day after earnings. Now the upper breakeven is slightly within the +1 SD curve so the strategy has less give to the upside.
Figure 5b Probability Cone for CSCO Iron Condor—One Day after Earnings
As a final image, Figure 6 displays the risk graph view the day after earnings.
Figure 6 Risk Graph for Nov-11 CSCO Iron Condor—One Day after Earnings
Next week the Probability Calculator and Probability Curves will be explored for this case study. It will allow changes to the model assumption and provide a more in-depth insight to the probability measures available to Platinum pro users.
As always, regardless of probabilities, remember that at the end of the day … anything is possible
Reading List to Consider
Marlow, J. (2001). Option Pricing: Black-Scholes Made Easy. New York, NY: John Wiley& Sons, Inc.
Taleb, N.N. (2005). Fooled By Randomness. New York, NY: Random House, Inc. (Original work published in 2004)
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.
