Focus on Standard Deviation
Feb 23, 2017
You don't need a doctoral degree in differential equations to excel as an options trader.
While there are a great many technical terms used in the options trading industry, the underlying concepts aren’t often that complicated. Standard deviation is one example.
The past movement of a stock plays an important role in estimating the potential range of future movement. In turn, the estimated range of future movement greatly influences the pricing of a stock’s options. In short, these are the primary concepts that make standard deviation important in the world of stock options.
An understanding of a stock’s standard deviation allows a trader to understand the “normal” expected range of a stock during the majority of occurrences through the lens of past performance.
According to theory governing standard deviation, an underlying will stay within 1 standard deviation range approximately 68.2% of the time, a 2 standard deviation range approximately 95.4% of the time, and a 3 standard deviation range approximately 99.7% of the time.
So, for stock XYZ with a hypothetical standard deviation of 5%, one would expect that on 68.2% of trading days, stock XYZ will settle within 5% its opening price. And on 95.4% of trading days stock XYZ will settle within 10% of its opening price. And on 99.7% of trading days stock XYZ will settle within 15% of its opening price.
The graph below from a previous installment of Options Jive shows a representation of standard deviation across a “normal” probability distribution:
Stocks with low standard deviation are therefore characterized by relatively muted volatility. The opposite is true of stocks with high standard deviations.
A better understanding of the practical meaning of standard deviation can help traders sanity check potential trades. It can also help explain why certain options appear “expensive” and others “cheap.”
To learn more about standard deviation we recommend you review the entire episode of Options Jive focusing on standard deviation.
Additionally, the search functionality on the tastytrade website can also be leveraged for additional information.
If you have any questions or comments on standard deviation we hope you’ll reach out at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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