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ODDS™ Probability Cones
Description
ODDS™ Probability Cones were developed by Don Fishback, renowned
option expert and originator of the ODDS option trading methodology.
Perhaps Mr. Fishback's most significant contribution to option
analysis includes the application of price volatility and its affect
on the laws of probability. ODDS Probability Cones are a result of
this work.
Fishback's ODDS methodology is based on the assumptions made in
every commonly used option pricing model. If you use an option
pricing model to value options, you are making the probability
assumptions used by ODDS, whether you realize it or not.
The assumption is that the financial markets are random and that
prices exhibit a normal distribution. That means that if you looked
at the market’s price changes over an extended period of time, the
shape of the price distribution would look like a bell curve. The
x-axis of a bell curve is in terms of standard deviations--the
y-axis in terms of price. A normal distribution assumption has some
very useful properties, including the one that is the most important
to us--probability is equal to the area under the curve.
The official definition of volatility is equal to one standard
deviation of the price change (expressed in logarithmic terms)
annualized. In simpler language, volatility provides us with a value
that can be used to measure the "likelihood" of a significant price
change. The higher the volatility, the greater the likelihood of a
significant price move.
Notice that volatility is equal to one standard deviation, which
happens to be the same unit as our bell curve’s x-axis. It is this
property that allows us to create the ODDS Probability Cones found
in MetaStock.
Option traders may find the expert named "Don Fishback – ODDS™
Option Analyst" helpful.
Interpretation
ODDS Probability Cones (which are greatly influenced by
recent price volatility) provide you with a visual guide to the most
probable range of future prices. This range (i.e. the cone's width)
is determined by recent volatility in prices, the number of time
periods projected, and the probability percentage (e.g., 68%
confidence, 90% confidence, etc.). The more volatile the security
prices, the wider the expected range of future prices and hence the
wider the cones. The cones always widen from the apex even if recent
volatility is very low, because as time increases, the better the
odds of a significant price move.
By default, the cones show the expected range of prices given a
68.26% probability (this is equivalent to one standard deviation).
This means that there is a 68.26% probability that prices will
remain within the cones over the specified time frame. By increasing
this percentage, you can control the width of the cones. As you
might expect, higher percentages result in wider cones.
The original use of this type of analysis was intended to help
option traders determine the best strategy to implement. From a
probability standpoint, an option trader would prefer to sell
options with strikes that lie outside the cones and buy options with
strikes that lie within the cones.
The cones also have equal value for the analysis of regular long and
short positions. All else being equal and assuming you are confident
in your price directional forecast, you would prefer to establish a
long or short position in a security with wide cones rather than one
with narrow cones. Of course, this assumes that the recent
calculated volatility will continue or rise. If you expect
volatility to drop, then you should reconsider.
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