How can I understand how
far a stock is likely to move?
The statistical distribution of prices ::
Normal distribution & Log-normal distribution
Normal Distribution gives equal chance of prices occurring either above or below the Mean (which is shown here as 0). We are going to use normal distribution for simplicity’s sake.
If
a price distribution is considered Normal, 68.20% of the time,
you will be within 1 standard deviation. Mostly, stock exhibits a normal
distribution/bell-curve. A normal distribution of data means most numbers in a
data set are close to the average, or mean value, and relatively few examples
are at either extreme. In layman’s terms, stocks trade near the current price
and rarely make an extreme move.
Implied
volatility (IV) is one of the most important concepts for options traders to
understand for two reasons. First, it shows how volatile the market might be in
the future. Second, implied volatility can help you calculate probability.
With
an option’s IV, you can calculate an expected range – the high and low of the
stock by expiration. Implied volatility tells you whether the market agrees
with your outlook, which helps you measure a trade’s risk and potential reward.
The historic volatility (HV) is the movement that did occur. The implied
volatility (IV) is the movement that is expected to occur in the future. When
we are estimating future prices, we use the implied volatility only.
Let’s assume a stock trades at Rs.50
with an implied volatility of 20% for the ATM options.
·
One
standard deviation move = Rs.50 x 20% = Rs.10
The
first standard deviation is Rs.10 above and below the stock’s current price,
which means its normal expected range is between Rs.40 and Rs.60. Standard
statistical formulas imply the stock will stay within this range 68% of the
time (see Figure 1).
All
volatilities are quoted on an annualized basis (unless stated otherwise), which
means the market thinks the stock would most likely neither be below Rs.40 or
above Rs.60 at the end of one year. Statistics also tell us the stock would
remain between Rs.30 and Rs.70 – two standard deviations — 95% of the time.
ü Standard deviation for specific
time periods
Since we don’t trade one-year options contracts, we must break
down the first standard deviation range so that it can fit our desired time
period, The formula is:
1 standard
deviation = Stock Price x Implied Volatility x (Square Root of [days to
expiration (22) / 256])
(Note:
it’s usually considered more accurate to use the number
of trading days until expiration instead of calendar days. Therefore
remember to use 252 – the total number of trading days in a year. As a short
cut, many traders will use 16, since it is a whole number when solving for the
square root of 256.)
Now, you can just use an options chain
to get an estimate of where the stock could move... Find the price of the ATM
straddle and the nearest OTM strangle and add them together and divide by two.
That is about equal to the 50% probability movement.
IV can help
you to determine the likelihood of a stock reaching a specific price by a
certain time period. That can be crucial information when you’re choosing
specific options contracts to trade.
Awsome information
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