$10,000 Income Portfolio

[Snuff_the_Rooster]

what's going on here is a probability calculation i think. ...............

probability of exercise increases, of course, as one moves the strikes closer to market price of the underlying. The rate of increase is a curved line, not a straight. My question is, do any of the greeks describe this progression ?

..................
for want of a better term i've been calling probability-of-exercise the jam factor

Maybe you're asking a question a notch or more above this, but let's start with the basics for anyone else that may be reading and are not aware of it. This probability-of-exercise is the delta(s). The rate of change of Delta is Gamma. I understand the natural inquisitiveness of traders but it's almost a moot point to attempt to read too much into it since things change daily and therefore your calculations would also necessarily change upon each incoming tick, every day. It would be a fruitless exercise to the bottom line unless your intent was to form a mid-to-heavy options pairing strategy upon strategy which I will admit we do often, but not for the reasons of being able to calculate a greek or a probability. For us at that point is purely hard P&L decisions.

The very nature of Delta and the Black-Scholes formula is as we know nothing but a calculation based on the Gaussian Distribution (with some practical modification over time) and so right out of the gate is a known flaw with respect to the reality of stock price movement.

The question becomes now one of asking ourselves how much error are we willingly letting ourselves be fooled by so as to make ourselves comfortable in our trade decisions. For us that answer is none at all. We recognize and appreciate the difference between hard numbers we can rely on and the other mental gymnastics we do to simply appease our psyche.

I suppose one could work out the curved nature of all the Greeks using the formula, but again it's been done for you by your broker so the question in my mind other than a personal satisfaction and increase knowledge, is why would you want to?

[Lephturn]

salut lephturn you can see how most option traders here are buzzing the strike price fringes of hi-volatility stocks; ie they are doing put & call spreads at strike prices a considerable distance from market.

But are they really that far from the market? It is often easy to look at something being $20 out of the money without considering how far that is in terms of a % move while at the same time comparing it to the realized or historical volatility of that underlying security. For this reason I like to use Bollinger Bands and tweak the settings to see what a 2 standard deviation move is for a particular stock. I will also change the settings for that indicator - I prefer 2.5 standard deviations, and I like to adjust the time period to shorter time frames when there has recently been increased volatility.

what's going on here is a probability calculation i think. Heaven knows i do enough of these myself. The idea is to work at extremities which probability suggests will never be exercised while staying in a super-liquid hi-volatility stock so that the premiums to be captured will be worthwhile.

probability of exercise increases, of course, as one moves the strikes closer to market price of the underlying. The rate of increase is a curved line, not a straight. My question is, do any of the greeks describe this progression ?

perhaps it's a function of gamma theta. I can see how the delta can be used as a measure, too. A low delta option will be further away from market; a hi-delta (i belong to the school that counts em as 100) will be ITM.

for want of a better term i've been calling probability-of-exercise the jam factor. However there has to be a better name.

below is a table showing aapl december 22 calls as of the close friday 26 october. Two pairs are underlined as an illustration, the 640/650s & the 690/700s. One can see that the 640/650s will bring in 2.50, with a clear possibility of exercise, while the 690/700 will bring in only .67 but the probabillity of exercise is greatly reduced.

all the pairs down to 600/610, which brackets friday's close at roughly 605, will form that perfectly curving line.

lepht you are the northern magus of option greeks. Any comment you might have to share would be so welcome.

While Delta can be used as a rough approximation of probability - and often is - one must always remember the limitations of the Black-Scholes option pricing model that underlies the calculation of delta. A good description is here: http://en.wikipedia.org/wiki/Black%E...es_in_practice

Basically the model assumes a log-normal distribution which does not fit the reality of price movements - the far out of the money options are more likely to land in the money than the model predicts. This is called "tail risk" in that if you draw a normal distribution curve the "tails" at the ends are fatter (more likely to occur) and the middle is slightly less likely to occur. The only thing this means to me is that I should buy insurance - what a market maker would call "units" - or very cheap far out of the money options to hedge in the unlikely event of a very large price change. In those situations, far out of the money options will normally increase in value far more than the model predicts, making them effective insurance.

In answer to your question about how the change in delta increases or decreases in a curve - yes this is measured by the option greek gamma. This is a tough one for me to grasp, as it is a 2nd order derivative - gamma is the rate of change of delta. I believe your "jam factor" is really gamma and you can get a good sense of it by examining an option chain not only for delta but also for gamma. To me the tricky part is understanding how "important" each greek is on the overall price of the option depending on how much time is left and how far in the money it is. I'm trying to get a good intuitive understanding around how the importance of the greeks changes as you get closer to expiry. The greeks are the best way I know to get a handle on what is happening, but you need to watch them change over time to really get a good handle on what's going on. I'm not there yet but I'm working on it.

[Lephturn]

@snuff,

I wouldn't want to calculate the greeks myself, but I do need to understand what assumptions they are based on and how they might be flawed. I agree with the limitations of the model and it's assumptions based on log-normal distribution.

I think we have the measurement tools we need in the greeks to understand how options pricing changes over time - what I am lacking is more visual tools. Something to take the greeks and graph them over time visually to help me understand how pricing moves and changes. Maybe I'm asking too much - heck I'd just like to be able to graph HV and IV to the same extent I can graph stock price without paying $ 250 / month for Live Vol!

[Snuff_the_Rooster]

I think we have the measurement tools we need in the greeks to understand how options pricing changes over time - what I am lacking is more visual tools. Something to take the greeks and graph them over time visually to help me understand how pricing moves and changes. Maybe I'm asking too much - heck I'd just like to be able to graph HV and IV to the same extent I can graph stock price without paying $ 250 / month for Live Vol!

I don't know all the brokers out there near well enough to know which one have this capability, but I have something that would work for you. Interactive Brokers has an excel spreadsheet you can download and using DDE you can receive all the options data they have - including the greeks. From there you can chart and graph and calculate away to your hearts content and watch it all, live. They've done the tough part for you already.

I agree, people learn best by looking at a picture, which is why when I show concepts like this, pictures are what I use most. A picture will stick quicker and longer, a table of numbers doesn't.

[avrex]

@Snuff. Can you assist me in finding this spreadsheet?
Is it via their "Trader Workstation" or "Web Trader" platform?
or is the spreadsheet located elsewhere?

[Lephturn]

Wow - another reason for me to open an account with IB.

I don't want to close my OX account yet - I really like them overall - but IB has insanely low commissions and now this.

Would you be willing to pull one of these out and show us? Like say for AAPL's Nov or Jan expiry chain?

[Snuff_the_Rooster]

@Snuff. Can you assist me in finding this spreadsheet?
Is it via their "Trader Workstation" or "Web Trader" platform?
or is the spreadsheet located elsewhere?

I'll clear a path right to their API front door for you.

http://individuals.interactivebroker...&ib_entity=llc


Check the Getting Started Guides tab as well for any help you may need.

I don't know if there's another way of doing it but the excel dde spreadsheet requires you to have TWS standalone installed and running. You need to check some boxes within TWS to allow for the connection to work also.

There are some help files about it somewhere I am sure.

[Snuff_the_Rooster]

Would you be willing to pull one of these out and show us? Like say for AAPL's Nov or Jan expiry chain?

There's no incoming market data today due to the closed markets in the US.

Calls and Puts?

How may strikes above and below ATM?

[avrex]

API front door http://individuals.interactivebroker...&ib_entity=llc

Thank you, from another 'Alice In Chains' fan.

[humble_pie]

lepht re " are they really that far from the market ? "

yes, most of the ones we see mentioned here really *are that far.*

avrex' stellar $20 above market call caper in amazon was indeed a rare close example & a highly successful one at that; but ottomh most of the spreads i see in this forum are far otm. Ask argo, ask meta, even gob sold a put pair in the 500 range which expired worthless (see gob's recent message upthread.) Leph you yourself had a put pair in the low 605/615 range, did you not. This is perhaps not so otm right now; however stk was north of 685 i believe when it was put on.

the way i see it, the challenge is to focus as finely as possible upon the strike price point at which a spread profit is maximal while probability of exercise still remains low.

somehow merely contemplating delta doesn't tell me all i want to know. As you say, intuition is important; although i've written upthread that i don't believe it is intuition so much as it is a sub-verbal or pre-verbal but precise understanding of how the number sequences flow.

(aside to snuff_the_rooster) markets will be closed tomorrow as well. If storm is bad in canada, even the tmx might shut down, which would automatically also close montreal.

perhaps given this data drought you might be able to show us your spreadsheet using canadian options from today ? potash was volume leader on montreal, followed by goldcorp. Januaries would be nice, would certainly appreciate this very much.