Index option trading with statistic(5)

I did not intend to make this topic as a series despite I have made four posts about it already. However, since I have also written another related post regarding probability on trading and it is closely related to what I term it probability trading so it is good to supplement some more info about this idea in this post.

Every short side option trader knows that option trading boils down into three key estimations prior to position building,
1. Direction of index movement, ie., above or below the rollover point at the settlement day
2. Range of volatility and the peak and valley of the month
3. settlement point

Naturally there are also concern on position size, strike picking, time of position building and long or short which are more on the risk management and trade strategy which varies from one person to another.

In my first post I mentioned that as long as one believes the index movement is the manifestation of the combat between bearish and bullish master players so it follows a structured pattern which history will repeat in somewhat similarity. Therefore probability from the past statistic could be a good reference for the inference of the future. This is the basis of my idea of probability trading, ie., decision based on the likelihood on what things will/will not happen.

The application of probability on the above mentioned three key aspects does not share equal weighing. In fact probability shows little implication on the first aspect, ie., direction of movement, because whether the spot month index will end up higher or lower than the rollover point is indeed random and is affected by the key events happen in that month which probability data fails to predict. Having said so, statistic does reveal that for HSI when the previous month has experienced a more than 10% fall then there is a 0.78 probability that the spot month will see a higher than rollover point settlement.

Probability does it job best on the second aspect, ie., the prediction on the monthly volatility and peak/valley. Statistic shows that 0.87 probability monthly volatility is below 3000 points and 0.73 probability below 2000 points respectively in the past 18 years. Naturally how accurate the probability data for a particular month can be depends on the design of the database which I mentioned in my first post. A sophisticated database which incorporates well designed sorting parameters does reveal a reliable probability of the volatility of a month for a given pattern.

Although probability data cannot predict the exact settlement point for a particular month but just like what it does for the volatility, it can show the probability of the how many points deviation from the rollover point. For example, it is 0.05 probability that any given month the settlement is more than  1800 points above the rollover point.

In my post  "is a trade worthwhile?", I raised the concept of odds and probability for the basis of whether a trade should be made at all. A well structured database can provide probability for the volatility and settlement point. The information of odds for index option trading for short side trader is even easier. Basically the profit for a short position is known when it is built. The potential loss depends on how the hedging is or what strike the protective long is put. The odds is just a simple maths.

As Charlie Munger puts it, value investing is all about looking for bets with 0.5 probability but with 3:1 odds. Through the use of database and the application of probability, index option trading can be more secured. The risk (probability of settlement beyond the strike of position) is foreseen and how much the profit is also known right at the time of position building. No more torture from the fear and greed. This is the essence of my idea of probability trading.

Good luck in trading!