lystn

Hey everyone. Welcome back to the daily call. On today’s call, I want to talk about options trading and expected ranges. I’m not really sure where I want to take this conversation, but I would definitely want to help people understand this concept of expected ranges, normal distributions… We’ll just use the word “normal distributions” because I think it’s easier to use than probably what the options market maybe really is or what the distribution of returns really are and we’ll talk about that here in a second. But I just want to talk about this concept because it’s really important to how we trade here at Option Alpha and really, how most back-testing and research is done. It also confirms a lot of this, so it’s not just that we’re saying this is how we think that the markets react. We know that this is how the markets react. We have a lot of data to backup what we talk about here and backup the strategies that we do. Every day, we’re doing more testing and more research and reconfirm or tweak or adjust what we’re doing. We’re not naïve enough to pigeonhole ourselves into one methodology or thinking. If we find that the research is pointing us in a different direction, we’ll go that direction. But the whole concept of expected range with options trading is basically this concept that the market implies some volatility expectation on a stock moving forward in the future. Market participants, not market makers… But market participants buy up either aggressively or not, buy up option contracts and basically imply an expected move in the underlying security and this expected move could be up or down. That’s the part that most people miss. They always think it’s just up or it’s just down, but it’s up or down. Let’s say we have a stock that is trading at $100. The expected move based on option pricing could be about $2 up or down by expiration. These expected moves and expirations can be different for different dates and different magnitudes, etcetera, but let’s just say the next expiration is maybe 30 days out, the expected move is $2 up or down. Now, that expected move just based on math and how it’s calculated for implied volatility using Black-Scholes methodology… You can use other methodologies as well. That expected move should encompass about 68% of the stock’s range. We should expect that if that expected move is played out many, many, many times in the future that the stock should land somewhere between $2 up and $2 down 68% of the time. Now, this is really powerful information. In fact, if you are just getting started at options trading, go back and re-listen to the last like 15 seconds of what I talked about. If you know or have a pretty good estimation that within 68% probability that the stock should move up or down by $2, that’s really powerful information. That’s information that you really can’t get any place else. The options market is one of the only markets where you can really get this type of information on a consistent basis across multiple securities and it’s actually really reliable. That's the first part about this expected range. Now, you can add out or you can expand out. Probably not add out, but you can expand out this expected range into one or two or three standard deviation moves. Now, what we just talked about, 68% range… I’m just rounding here. But a 68% roughly range is what’s called a one standard deviation move. It’s on a normal distribution bell curve. It’s a one standard deviation move. If you went out two standard deviations, that’s encompassing 95% of the expected range. If a one standard deviation move let’s say is $2, let’s say a two standard deviation move is $4, 95% of the time, the stock should trade between $4 up and $4 down. Again, very powerful information as you start building out option strategies. You can build out options strategies that basically take this information and then create high probability setups. Now, the only rub that I have with normal distributions is that what we find in actual real-life is that most stocks do not trade in a perfectly normal distribution. Now, we use this as a teaching tool here at Option Alpha and I talk about this a lot and use this asterisk at the bottom to talk about normal distributions, but most of the time, stocks trade in a normal distribution fashion, but it’s not perfectly normal distribution and what we often find is that stocks actually have what are called “fat tails.” Although it might have a 68% chance of trading up or down by $2, there might be actually a slightly larger percentage of stocks that make a three or four standard deviation move. Now in most cases, a three standard deviation move happens less than .1% of the time. We’re talking about moves that happen very, very rare. But we might find that that might actually happen .3% of the time or .4% of the time where a stock actually makes a four standard deviation move in a given month. Again, very rare to happen, but they do happen. What we find is that when stocks generally crash up or crash down, they crash up or down in a very big fashion. That’s why I say it’s kind of like a normal distribution with a hump in the middle and then you’ve got these fat tails on the end. It’s not that the stocks have these huge risks of necessarily collapsing or crashing up. It’s just that those risks are present. We often find that stocks, when they start moving in one direction, get a lot of momentum and then continue moving in that direction and not make the normal distribution so normal. How do you overcome this? You overcome this in one simple way and that’s just position size. Everyone always ask like – “How do you protect yourself from a fat tail risk, from a black swan type of event?” Well, you don’t have all of your eggs in one in basket. It’s really as simple as that. You diversify out across ETFs, across stock tickers and just keep your position size in check. If you do that, you pretty much take care of 99% of the problems that you might have where you’re not totally invested in one security or one industry or one sector that might have just a random event that blows you up. That's what it comes down to. But for us, when it comes to expected ranges, I mean, it’s really where we trade most of our securities off of. We are always looking at the probabilities, the expected moves that the stock is going to make and then trying to build positions around that. Now again, the last thing that we’ll talk about here is obviously that implied volatility is a really bad judge of future movement and this is something that’s been verified not only by our research, but like countless other studies and research firms, universities, etcetera. It’s that implied volatility is a really bad judge of future expected move. What I mean by this is that when the market assumes that the stock is going to move… In our case in the example we were using, assuming that the market is going to move up or down by $2, what we actually find is that maybe the stock moves up or down by $1.75. Implied volatility always overstates the expected move long-term. That means that obviously, the stock could move the first month, could move $2.10 and the next month could move $2.10 and the next month move $2.10. But long-term, if we keep looking at the same type of setup over and over, we find that the stock moves on average let’s say $1.75 and the market expected a $2 move. Again, it’s not to say that the stock can’t move outside of that range. It’s just that on average, it won’t. We've again, verified this with our research. You can go online and look at other research out there. It all verifies the same thing. Expected move and implied volatility is a bad judge of character if you will and really overstates what the stock might actually do in the future. Hopefully this conversation helped. I know it was a little bit more in depth. It wasn't necessarily a beginner topic, but I think it was important because we talk a lot about expected ranges and again, it’s good to clarify how I think about normal distributions. Be not so normal when it comes to stocks obviously in thinking about that fat tail risk. As always, hopefully you guys enjoyed these. If you have any comments or questions, let me know in the comment section. Until next time, happy trading!