Papale on Standard Deviation

My favorite show on TV is “Gold Rush”.  If you haven’t seen it, it follows 3 gold mining crews as they mine for gold, mostly in Alaska.  I really like this 18 year old kid named Parker, who loves his grandfather and is determined to do whatever it takes to find the gold.  He faces ups and downs, hope and despair and one issue to deal with after another.  Kinda reminds me of how it was with my butterfly last month.

Many options strategies are set based on an expected magnitude move in the underlying.  If you are a butterfly or condor trader you know that it is not really the direction of the move but how much it moves.  Probably the most common measure to estimate the magnitude of an expected move is standard deviation.  Standard deviation is a statistical measure of movement either up or down based on a volatility input, number of days and an underlying price.  We then can get a probability estimate of a price range of an underlying over a time horizon.

When we speak of one standard deviation we mean that there is a 68% expectation that the price of the underlying will stay within the range estimate over the time we specify.  Two standard deviation shows with a 95% expectation  the price range of the underlying for a given time period.  We can then use these probabilities to determine where and how to place our trades.  Strikes in the second standard deviation are less likely to be hit than strikes in the first standard deviation.  So by using statistical expectations, specifically standard deviation, a trader can use historical price behavior to help predict future price expectation.

Comments are closed