Optimal Strike Selection of Options
In this articles we will discuss how to determine strikes of your option trades. You want to select strikes which gives you the optimal price risk reward. With the selection of strikes you determine the amount of risk you take. The use of the Probability Model and Standard Deviation is very helpful.
Standard Deviation is a measure of how spread out numbers are. Its symbol is the greek letter sigma. Trades who make use of the Probability Model often referred to as probability traders.
What is the Probability Model?
Volatility Traders use the model to determine trade risk and Probability Of Profit (POP). The model often referred to as a “Bell curve” patterned after the geometric Brownian Motion (as applied in the Black-Scholes model). It explains the normal distribution of random outcomes. In our case the random outcome of asset prices. In other words, we are statistically determining the probability that the price of an asset will fall within a range over a specified period of time and current level of volatility.
This relies on the fact that you cannot predict how much the price will move of a stock (or index) and in which direction it will be. It is predominantly random. Much research has been done in this area, and it has been shown that the price action of indices like the S&P500 or the Russel are predominantly random.
There are three key inputs to the Probability Model that probability traders focus on: price of the asset, implied volatility and days to expiration of the option. It then becomes a simple matter to determine the range of prices and the POP based on the expected move for a given level of risk.
Look at the picture above to determine strikes. Risk is measured by standard deviation (SD) this is the blue part in the diagram. With 1 SD representing a 68.2% probability the price will fall within that range at expiration. When you select 2 SD then 95.4% of the price movement will be in this area.
Note: the POP for one side (Put or Call only; not both) would be: 1 SD = 84.1%; 1.5 SD = 95%; 2 SD = 97.7%. and 2 SD representing 95.4% for strangles and iron condors (ICs). The Expected Move for 1 SD is: Price x IV x sqrt(DTE/365).
How to determine strikes
For example, if an index has a price of $1,800, DTE of 7 days for the option, and IV of 17.2%, then the expected move (EM) for 1 SD is 42.9. Therefore, the Put short strike at 1 SD would be 1755 (EM rounded to 45); the short Call strike would be 1845.
How reliable is the Probability Model? For the SPX, it is quite reliable. Keep in mind, that the shorter the Days To Expiration the more reliable the outcome, since IV is not fixed and will change over time as markets are impacted by future events.
The Probability Model provides an objective approach to locating the short option strikes for a high probability option strategy.
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