OPTIONS
Skewed Statistics
Setting Strike Price Probability At Expiration
by David White
Here's one way you can increase your odds for a short-term play.
Nassim Taleb's exceptional book, Fooled
By Randomness, helped me finally gain the proper understanding of the
probability of hitting a strike price at expiration: "The statistic that
90% of all option positions lost money is meaningless (i.e., the frequency)
if we do not take into account how much money is made on average during
the remaining 10%."
Let's take a look at what this means.
PRICE AT EXPIRATION
Setting a real-odds number is impossible, as Taleb comments, but there
is real information in the bets that people make in the market. For example,
I found a website (www.iqauto.com -- click on "maximum pain opts") that
gives a strike number where the stock price is most likely to be at expiration.
This number is based on finding the centerpoint where the most money would
be lost at expiration.
This theory is based on pretty solid ground if you look at other areas
of life, such as horse racing. At a pari-mutuel horse track, the odds that
are the basis of the payout are calculated by the wagers placed. Just as
in the options market, 90% of the time the odds are correct. The tracks
pay out 80% of the money, so the only thing they care about is how much
the bettors put down, not the way they pick their bets. Nine times out
of 10, they skim the 10% difference as profit.
Determining probability by wager has also been used for more surprising
purposes, such as finding a submarine lost at sea -- within 1,000 yards
(see The Silent War by John Piña Craven). Given a decent
sample size, accurate odds can be made on just about anything with this
method: Just get enough people together and then bet on it.
Unfortunately, with the financial markets, it's not so simple. In practice,
the indexes sometimes expire significantly away from the indicated strike
price. Stocks are hit-and-miss, with no apparent reasoning to guide their
movements. This suggests that while there is something to the theory of
probability by wager, it is not useful in the markets yet.
FIGURE 1: SPX OPTION EXPIRATION CURVE (6/13/04). Here,
the maximum loss point is 1100 and the skew point is 1060. This means that
the suggested expiration strike price range is from 1100 to 1140. The option
settled at 1129.60 and closed at 1135.02.
...Continued in the December issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the December 2004
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2004, Technical Analysis, Inc.
Return to December 2004 Contents
