Standard Deviation for Finance Illiterates

“Its not gambling if you know you’re going to win.”

Standard Deviation is a measure of the amount of variation in a set of values. A low standard deviation indicates that the values tend to be close to the mean of the set, while a high standard deviation indicates that the values are spread out over a wider range. In trading, the volatility of an option is equal to a 1 standard deviation expected move.

A stock will close within…

-1 SD 68.2% of the time

-2 SD 95.4% of the time

-3 SD 99.7% of the time

If we sell a put 1 SD below the stock price, it has an 84% probability of finishing ITM.

The further OTM we sell a contract, the higher the pop, but the smaller the credit received.

A put selling strategy outperforms tradition investment strategies. e.g. it beats the buy & hold strategy in both P/L & ROC.

Selling puts is effective even without management & entering the trade regardless of implied volatility. It’s shown that managing winners and selling premium when IV percentile is above 50% can vastly improve ROC and probability of success.

While we generate a greater return selling the at-the-money put (3.14 times more) and also saw a greater variance in P/L (3.08 times greater). While both strikes proved profitable, going further OTM provides the best opportunity to manage a winner and most efficient use of buying power in small accounts is in selling the 1 SD put.

a.) 1 SD put | b.) 1 ATM put

# of winners

a.) 49

b.) 41

% of winners

a.) 94%

b.) 79%

P/L

a.) $1,878

b.) $5,893

SD returns

a.) $456

b.) $1,407

You trade using high probability, but…

-not enough occurrences (trade often)

-not enough premium in sale (low iv)

-too close to atm sale (wrong strike selection)

Improper time frame selection

-selling weeklies with little to no premium

-too much time to expiration leads to a decrease in ROC as theta decay is much less longer durations

Buying vs selling premium

Probability of profit for the seller

OTM: 80%

ATM: 53%

ITM: 50%

Probability of profit for the buyer

OTM: 20%

ITM: 47%

ATM: 50%

Takeaways

-premium sellers can win 2/3 ways

-sellers benefit from IV contraction

-buyers benefit from IV expansion

-selling OTM & ATM options allows us to obtain >50%