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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
Pro.
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. |
