How can understanding standard deviation help us trade?

Linda please fire it up best practices today is determining strikes around standard deviation and probabilities we decided to hit them where it hurts hit them where they ain't actually somebody somebody sent me an email out of the other day and they said I just I just don't understand the whole concept of you know being contrarian and I said well part of it is hitting them where they ain't and they go okay now I get it and the other part of it is if I say black you like to say white just to rile me right well most people like that aren't they yeah I think so I think so yeah yeah I think they're they like some good intent intellectual discourse I actually thought thinking goes against human nature like against kind of the to a to do what everybody else wants to do but yet people do that when it comes to investing I don't think we do that when it comes to anywhere else I think I think it's more lack of confidence than anything else I might wanna run with the crowd Mike North will come in here to talk about sports and he'll do the exact opposite of anything you want to do sports wise but if you said you like some stock you go I like that stock - yeah same thing um determining strikes around standard deviation let's go Linda please what are the main factors that affect our choice of strike selection when placing a trade okay so we really planned this to be a basic more beginning oriented best practice so really all this is about is how implied volatility and your probabilities of expiring out of the money or in the money affect your strategies and affect your strike selection so if you have you know the things that affect your strikes if implied volatility is high you're gonna your strikes are going to be wider it's the probabilities are going to be the same probably you're still going to choose strategically the same type of percentages out of the money so maybe you're doing an iron Condor where your short strike is 68% or a strangle where your short strike is 84 or 90% so the main factor is implied volatility volatility so you may be doing you know strikes one in and and if implied volatilities hi you might be doing strikes zero and six so you know I'm just picking numbers but just to show it's wider it's the same probabilities but as ID goes up your strikes change and it comes in they get narrower so your quote-unquote pot ads get get worse on Saturday morning I did a lecture at Tech Week and one of the topics was standard deviation as it relates to entrepreneurship hmm interesting and it was almost no different than explaining this like one of the takeaways from from tastytrade that makes I think our stuff so interesting and quote investable is that you're able to put context around your decision-making that's that's important to do because otherwise your decision-making is you know if there's no relevance you can't you don't you're not engaged with whatever the decision you make is it's you can't you don't buy into it but if you understand it so I did a discussion on standard deviation as a replaced as it relates to an opportunity for success and suggested that you know in a roomful of a hundred people sixty eight people in this room or less somewhere inside that are going to fall into some normal level of either mediocrity or success or small failure but you'll survive but it may not be that interesting fifteen or sixteen percent you're going great and fifteen or sixteen percent you're going to make it and on the fifteen or sixteen and the percent that are going to make it you know one two or three percent are going to really hit it out of the park so there's three people in this room that we're going to be reading about a couple years from now there's ninety seven people that were not mm-hm and and so you know I just wanted I want to throw it out there so the expectations are realistic when we talk about standard deviation as it applies to risk it's the same thing so I mean I'm just I'm jumping ahead but just for a second when you think about the risk that you take on your positions about two or three percent of the time which is that full two standard deviation move you're end up with a position that goes horribly against you right oh but that's just the odds which means that the other 97% of the time of course you can lose money's a lot but the other 97% of time you're not gonna have that horrible trig against you right so that's the hole so how much can you make on the other 84 traits and then then stay in line that's right and how much can you make on the other don't forget you have some couple minute for as many giant losers you're gonna have a couple giant winners right and then on the giant losers the ones that go does those three how much can you make on the other 97 trades or eighty-four trades ever you want to say that you're able to you know in the end make money on and that's one of the things about context it has to do with implied volatility strife selection everything else about standard deviation is just understanding that hey this is what its gonna break down like you're not right and you know taking your analogy one step further going trying to implicit implied volatility into it you're talking to the entrepreneurs in a really good environment and a really good segment maybe tech is hot and and the environment is good you'll have more people falling into that even though the percentage is the same you'll have more people coming into the marketplace you'll have more people succeeding so implied volatility you know the whole analogy can be carried for there let's on their side so how do you determine what the significant what is the significance of a one standard deviation move okay so we talked about this a lot just by definition statistically one standard deviation encompasses 68.2% we we rounded to 68 percent for simplicity but it encompasses sixty-eight point two percent of all occurrences so the way we apply it when we make our trades is if 68 percent fall within the curve that means 32 fall outside of it and as you kind of alluded to 16 is on each side so those of us that use probability of in the money if you want to do a one standard deviation strangle you're going to go to 16 percent on each side if you use out of the money it's 100 minus 16 so it's 84 percent and that's what we use on our platform so the significance is just to put um just definition that's right it just just provide kind of like the the ultimate and definition can be directly attributable to whatever the pricing models we use our right and standard deviation again when in the mathematical derivation of our models standard deviation is volatility right it they're the same things they're synonymous so that's why we talk about standard deviation all the time we talk about volatility all the time and a lot of people don't equate them they are the same exact thing mathematically and how is it different for it I mean just think about this here's the cool thing about what we do here because there's almost you can take this and you can apply it to almost any other business - absolutely it's these are mathematical facts right right it's not so we talked about earlier hey you know what you're looking for your major in school mm-hmm it's just kind of cool hmm um hey Linda if that short video I sent you before won't show you something it's movie time the one who's a prop comic last week and this week he's gone to video now we have a Senate last morning please give a listener who sent me I would talk about colleges and models just look at this girl she's five shadow can I ask you a question when the market goes up like this what do you call it okay when the market goes down like this what is it okay what about if the market goes like this cool give me an example of a strategy you can use to make money on a sideway market picture of okay thanks that's amazing that girls five yeah okay you want to talk about changing she will forever be immersed in financial literacy to a degree now remember at five okay I couldn't get my son to speak yeah pretty much you know right like forget about using the forget about actually quoting bullish bearish sideways are buying butterflies using terms yes using terms like barely good to say thank you where we've reached we're starting to reach into and change everything in its very core can you imagine a nine-year-old being able to explain standard deviation and how it relates to a lot of decisions they make in life and then applying that to whatever their major is their math their math skills there's a change going on we're kind of at the core of it and it's so cool so thanks for sending in that video but then we go back to Linda to the next one I just want to show you because I think that you know we're learning standard deviation or we're talking abouts and deviation to most people for the first time outside of like a craps game right BAM back in and it was some year in the past I taught business statistics at the college level and I had a hard time getting them to you know understand one standard deviation two standard deviation and now all our viewers they get it it's amazing I took I went to in grad school I took statistics and I couldn't stand the class yeah cuz it was so boring nothing was I couldn't apply anything at least I didn't know how I was gonna apply anything and it just it drove the class itself I thought this is the dumbest stuff ever and now we're sitting here talking about you know so basically statistic you didn't take my class my class Oh fun all right well whatever is we applied it right so we did yeah my professor did not apply it I didn't even understand why I was learning this stuff it seems so ridiculous to me see my students could tell you what the one standard deviation chance of of having two two one girls two guys at a particular bar in a particular day and that was important to coeds and guys at Beckman but we didn't have a professor nearly as oh my god that was my one time if I could was turn editing so how do we determine what is the significance of a to standard deviation move we talked about this last week two standard deviations is where the the brokerage firms clearinghouses define undefined risk this is the point right there ninety five percent ninety five point four five is the exact we round to ninety five so you have two and a half percent chance of being outside that on either side and that's two standard deviations that's the definite of undefined risk so it's cool because in a very short period of time here we're able to talk about the significance of a one standard deviation move and the definition of a two standard deviation move with respect to risk or undefined risk everything else and again what that means is that over a certain period of time if you make I talked about yesterday during my live class if you if you make a hundred trades I'm just going to be really simple examples and five of the and five of those hundred trades you go to max loss of two standard deviations approximately how many trades does it take to make up your max losses standard deviation you know a to standard deviation and I'm going to tell you it makes it takes between thirty and forty trades it takes away but you still have 50 trades are profitable mm-hmm so it's it's you know it's interesting to try to when you when you think about the just a brought the huge numbers and you think about what max loss really is it's just incredibly interesting to understand how much juice there is left if you put on lots of trays right and again stay small crate size is really important and we never knew that before something we learned over the last oh we avoided too big because you had to write cuz you know what that was felt like we had to well that's what your ego told you to do and that's what everybody else just told you to do if you want to be somebody had to trade big right Tony had no ego he didn't he had he had an ego that was the size of I don't know Illinois but he but he didn't in the trading world he could check it it's good why he was successfully had me yeah all right on our platform what is mmm and what what does it calculate why is it only show up sometimes okay so we generally don't like to talk about any specific platform but we put a lot of earnings that's correct lays and mmm shows up at the top of the screen at times and actually Tony and I had a really interesting the day you were gone we were looking at it in earnings play and we were looking at the mmm and we were looking we kind of lined up a trade we came into last call and mmm was gone and everything had changed so we just wanted to kind of get out here mmm is just it's out there when the front month has a much higher volatility than the next cycle and the next cycle and so it looks for that differential and when the front month goes really high one of two things has happened either the entire market is crapped out and volatility has has expanded tremendously and we've gone from a contango into a backwardation on the and the implied volatility or 99.5% of the time is just because there's a binary move earnings being the main one so that's what it is it just looks for that differential and volatility and it is an estimator of a 1 the overnight expected move one standard deviation expected me is it's a market measure move market maker move and it was the it was it was originally designed just to take the guesswork out of looking at the front month straddle in the back month strangles and add them all together or whatever taking what is a place to start it's just a starting point Roetzel absolutely get it let's go next one when volatility is high what impact does this have on a standard deviation move how does it change our striking strategy selection okay so I mean again these are just really basic type of concepts but as volatility goes up as we talked about one standard deviation strikes get wider then the distribution curve if you think about it gets wider and flatter so that one standard deviation move gets wider it gives us more comfort and more opportunity to sell so that's when we're looking to sell premium we're much more active in a high violent beautiful very simply okay let's go the last one when ball is low what impact does have on a standard deviation movement has to change our strike selection okay so just the opposite it moves them in and what does that mean to us um a lot of times lovel environments will last for a long time so you can't be afraid to trade in them but we do get we get a little bit more defensive so we maybe put on a little bit smaller size you have to put on smaller size because what we want is that when volatility is low you have to decrease your size because you can change your trading methodology except to decrease your size when volatility is high we used to think you had to decrease your size to take it because you'd be getting the same bang for your buck with less money yeah we were a hundred percent wrong right the opportunity to get that's right bigger but the big thing to remember is that you have to kind of lower your expectations when vollis low your not going to get as much premium told you to trade smaller change your expectations and just trade to what's giving you there's still plenty of money on the table in a low vile environment when you move your size down maybe you even widen your strikes a little bit to anticipate a little bit of mean reversion in the IV to where your strikes would widen out but just it's a mental change once you've gotten that mental change you just go on trading totally agree and it's something that most people you know including ourselves missed for a long time and I should say we miss we just didn't know right exactly learnt a lot it's a very short prick it's so simple and yet it's not easy it's in front of your face you just can't grasp it I would years twenty years as a professional trader and I never once thought about volatility with respect to size never once like worth on day one Monday if volatility was cheap and I want to make a trade I'll do his maze I can do and on day three if all till he was really low I would do the exact same thing you know never ever occurred to me that I should be reducing size with respect to implied volatility ever right nobody does good stuff right now that was great thank you mmm-hmm we're gonna come back we're gonna do a little opening bell stuff we got a lot to talk about Tony back in 90 seconds this and get taste on the taste trade network you

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Length: 16min 53sec (1013 seconds)

Published: Mon Jul 01 2013