The probability of the put with 90 DTE dropped more than the put with 20 DTE.Īs time passes, a change in volatility has a smaller impact. But it drops more when there are more days to expiration. This shows that no matter how many DTE the option has when the trade is put on, as time passes and volatility rises, the probability that the option will expire worthless drops. These are the probabilities that the 95 put will expire worthless (POE, probability of expiration) at different times to expiration (DTE). Assume the investor shorts the put when volatility is 20%, then one week later volatility is 30% and the stock is still $100. It’s a bullish strategy, typically with a better than 50% probability of making a profit. Was the trader’s original decision wrong? Or how does the trader adjust?Ĭonsider a short put with a 95 strike price on a $100 stock. But higher volatility pushes the sides of the normal curve higher, which means there’s a somewhat higher probability that the stock will reach a higher or lower price when volatility is higher.īut if a trader makes a decision based on probability-particularly a short options strategy, like a bullish short put based on current volatility-the volatility changes and changes the probability. The shape of the curve doesn’t change much, with the highest probability that the stock will stay close to its current price no matter what the volatility. The height of the line indicates the probability. Volatility affects probability via the normal distribution curve, and that curve gives us the probability that a stock will reach a particular higher or lower price.Ĭonsider three normal distribution curves (in the chart above), each based on a different volatility: 20% (green), 25% (blue) and 30% (black). So, what happens when an investor makes a probability-based decision when the stock has 20% volatility, and then the stock’s volatility moves to 30% the following week? When those factors change, volatility can change, too. Examples include earnings, product releases, government decisions and the economic climate. Factors that could cause a stock to have larger or smaller price changes are compressed into volatility by market activity. It captures the market’s opinions right now about what the stock might do in the future. A lower volatility means larger percent price changes are less probable, and a higher volatility means larger percent price changes are more probable.īut volatility is a snapshot. That probability number is heavily dependent upon an estimate of the volatility of the stock. When an investor knows the probability that a stock that’s now $100 might drop to $95 in the next 45 days, that can be the basis of a potentially successful trading strategy. That means attaching a probability number-between 0% and 100%-to where a stock price might be at some point in the future. But when it comes to investing, it’s preferable to keep entertaining guesses out and quantifiable outcomes in. It’s fun to speculate about cultural, political or economic events that might happen in 2023. Get serious about investing by attaching a numerical probability to every trade
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