How to interpret the outcome probability chart ?

Discussion in 'Option Risk Calculator Forum' started by status1, Jul 2, 2017.

  1. status1

    status1 Well-Known Member

    I was playing with that option risk calculator but I am not sure what I am looking at when I look at the outcome probability chart
    In case of a wide iron condor I have a 31% chance to make the max amount but if I look at it about 2 weeks before expiration than it looks like there is no chance to make any money while the profit area is quite wide
    Why is that ?
     
  2. Could you generate and post the URL for your problem? You can do that from the menu when you're viewing the risk chart.
     
  3. status1

    status1 Well-Known Member

  4. For the target date you've chosen (8/18), the risk chart does not show a positive P/L anywhere - you're waiting for some time value to bleed off. If you move the slider out to the 9/15 expiry, you'll see a couple of profitable price ranges, and you'll see that profitability reflected in the outcome probability chart.
     
  5. FYI, whenever a tool like this estimates P/L before expiry, it must calculate a theoretical option value using the Black-Scholes model. So any estimate of trade value and P/L prior to expiration must take that into account. To see how carefully you have to tread here, move the slider all the way to the left and see the forecast that, the day after you open the trade, the position will be worth around 5K less than where it opened. Why? Because it's estimating the option prices using the inputs you supplied, including 20% volatility. The prices in your initial positions imply volatility in the 5-15% range, so your choice of 20% volatility is questionable. Needless to say, the choice of volatility is a critical input both in estimating trade value before expiry and in the predicted probabilities at expiry.
     
  6. status1

    status1 Well-Known Member

    Thanks for the explanation but this sounds a little more complicated than I thought
    I thought maybe I can use this to estimate the p/l at a certain time before expiation but it looks like this is something else
     
  7. DGH

    DGH Administrator

    Excellent summary and explanation, Nathan. Status1, it is often useful to examine the overlay of the payoff curve (red line) and the distribution curve. In order for a strategy to have a good likelihood of profitability based on probability alone, the payoff curve must lie above the zero line (for the time duration chosen) throughout a good portion of the distribution curve. Otherwise, the strategy relies entirely on luck in order to win. In your example the only chance of success lies within a very narrow range (approximately 1/2 SD on either side of the median) at expiration. An exit prior to expiration shows that very little of the payoff curve lies above zero. By contrast. here is the URL link for my 15 SEP Road Trip Trade.
    http://option-risk.appspot.com/Opti...B7_N4v734o73YfW9vfN7_M79y2b5JFWvdKiYOsBp0SfIC

    Naturally, I am biased towards our RTT strategy, but I think it provides an instructive example of a "good" setup in terms of probability. Note the broad range of profitability (viewed on 1 SEP, with 14 DTE) on the left side of the median. There is even a small positive component of the payoff curve to the right of the median. Of course, as you know, part of the strategy of the RTT is to raise the right side of the payoff curve gradually and safely with the use of timely Reverse Harveys and added layers. The fact that the RTT has, basically, a one-sided risk (since I will elevate the curve above zero prior to exit) contributes to its positive expectancy and to the fact that it has an attractive equity curve, profit factor, and Sortino ratio. So, the RTT does not rely on good luck to win. It is only hurt by "bad luck", that is, by a sudden market drop of greater than 5% to 7%. I think it would be informative for anyone interested to check out various strategies by first "eyeballing" the overlay of the payoff curve and the distribution. That's the beauty of Nathan's tool. Then, the user can gain added information by trying various exit times and by running the Monte Carlo simulation. The tool allows a quick comparison of "apples to apples" based on probability performance alone.

    d
     
    PK likes this.
  8. Status1, you can use it to estimate trade value and profitability before expiry - you just have to understand that a calculation is only as good as its inputs, and those inputs are based on assumptions about markets that do not sit still and behave. I'm new here and haven't studied RTT, but I plan to - Dan clearly has put thought into the inputs, and also designed the trade to respond to those squirrelly markets, avoiding the temptation to sit on his assumptions.
     
  9. Greg K

    Greg K Member

    I guess I don't understand what the yellow line represents
    When I hover over the line near the upper right corner what does that represent ?
    Using Dan's url link and moving the slider all the way to the left Jun 28 looking at the yellow line it shows the p/l as 1627 on the top right corner
    What does that mean ?
     
  10. DGH

    DGH Administrator

    Hi Greg. The yellow line (seen after running the Monte Carlo simulation) represents the probability expressed as a percentile function. I'm not sure about your "all the way to the left June 28" notation. The simulation should be performed with the original overlay graph set at expiration or, preferably, several days prior to expiration. I examined the 1 Sep graph for my 15 Sep expiration. Then, using the percentile graph, it is possible to see the "Probability of closing at or above" by hovering over the line at various points. Here is my percentile graph: http://imgur.com/a/Uhj13 Note the mean P/L and probability of break even. Note also (by hovering over the line) that the probability of losing more than the initial cost of the butterfly is only about 13% and that there is a 40% chance (hover over the 60 percentile area) of a profit of $2725 or greater. This is my method for analyzing Nathan's calculator. If you have other questions you might wish to review Nathan's presentation of the Calculator and my presentation regarding its use with the RTT.
     
  11. Greg K

    Greg K Member

    By all the way to the left I meant instead of looking at 1 Sep go all the way back at the beginning of the trade in this case jun 28 so that is all the way
    Basically you are looking at it right after you placed the trade
    Unless those are bogus numbers it looks like there is a small probability to make 1627 which doesn't seem possible
    unless the vol gets crushed in this already low vol market
     
  12. DGH

    DGH Administrator

    The tool is not designed to examine the trade outcome on day 1. Please refer to my post above and to the presentations. The tool is designed to analyze probability performance at a future date, such as 15 DTE, just as we would in live trading.
     
  13. Kevin CK

    Kevin CK Active Member

    Very interesting tool, will play around with it and thank you for the detailed webinars explaining how you have used. I was wondering if it's possible to model/factor in adjustments for trades. I'm guessing that is a bit too complicated given the timing and variety of possible adjustments and associated adjustment points, but I thought I would ask anyway given that most butterfly trades without adjustments would not have a positive expected return.

    Kevin
     
  14. DGH

    DGH Administrator

    Hi Kevin. Yes, most ATM butterfly setups do not have a positive expected return. The RTT setup does, of course, as you can see in my link posted above. No, it is not possible to factor in adjustments with this tool since it is designed for pure probability performance.
     
  15. Let me restate my caveat about looking at results prior to expiration: don't do it unless you really understand what it's doing. At any time before expiration, it's estimating the trade value using a pricing model (Black-Scholes, of course), and that model may not match reality, even on the day you open the trade. The reason Dan's trade shows a loss on day 2 is that the model doesn't match the prices used to set up the trade.

    If Dan were to set up the same trade but leave the "Premium" fields empty, the tool would calculate theoretical premiums based on his inputs (1% risk-free rate, 11.79% volatility). These values are wrong because the market is always right, but that's a good way to see how pricing models diverge from real-world prices and why you have to take such results with a grain of salt.
     
  16. Marcas

    Marcas Well-Known Member

    I just watched Option Risk Calculator (ORC) presentation. What a great tool! Thanks Nathan!
    Now I can see, not guess anymore, rough probabilities of strategy in different market conditions.
    I don't expect to eliminate limitations of ORC and still keep this tool free - I'm not even sure if this is necessary for account sizes most of us trade here.
    One small suggestion/request: maybe it would be possible to generate numeric output for users for future analysis,
    and one question - is the source code available somewhere?
     
  17. Thanks Marcas. Please see my "Suggestions for Enhancements" thread - I'd like to collect enhancement requests there rather than have them scattered among other discussions.

    The source code is not available., but you'll find a pretty detailed discussion of the calculations on the documentation pages, if you're interested in writing a better tool.
     
  18. Marcas

    Marcas Well-Known Member

    thanks. I'm not thinking of new tool but rather of incorporating some ideas into backtester I'm working on. Not sure yet if I need to to do it at all - your implementatin may be sufficient.
    I'd love to see stand-alone version though.
     

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