How can you go about selecting the best strike price for writing an option?
Perhaps no branch of knowledge
has been as abused or misunderstood
as statistics. Yet, without
some grounding in basic
statistical concepts, our ability
to trade profitably is limited.
Trading does not require a doctorate
in mathematics, but mastering
some basic fundamentals
should help stack the odds
in our favor. This is particularly
helpful in developing an options trading strategy.
Many trading software packages automatically generate
statistics on any tradable or indicator; often included are
mean, median, and standard deviation. Although most people
understand that a standard deviation is a measure of how
volatile an asset is, beyond that, their understanding is fuzzy. Yet a wealth of information is buried in that number.
To understand the standard deviation, you must first have
some grasp of what the normal distribution is. Although
entire academic careers have been devoted to arguing whether
the market is random, if you were to graph the percentage
change in the stock market over any period and then graph the
frequency of each percentage change by interval as a histo-gram,
you would get a bell curve. This bell curve conforms
closely to what one would predict mathematically if the
market were a random process with a slight upward bias.
For example, if you were to measure the four-week percentage
change in the Standard & Poor’s 100 index (OEX) for
all rolling four-week periods (close of the last trading day of
the week through the close of the last trading day of the next
week) from October 1976 through December 1995, you
would get a distribution with a mean of 0.7% and a standard
deviation of 3.9%.