The Skinny on Options: Abstract Applications

Bayesian Updating

The Skinny on Options: Abstract Applications

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

As traders, we are constantly processing information and making decisions, as new information presents itself. This process of evaluating our original hypotheses and making the necessary adjustments is known as “updating” in the Bayesian world. Using a combination of inductive reasoning and deductive reasoning, the Bayes’ Theorem Formula shows how the probability of a given hypothesis is determined.

For our purposes as tastytraders, however, all of these numbers are calculated for us in the marketplace, such as Delta, Probability of Profit (POP), or even P50 (using Monte Carlo Analysis - the probability that your position will reach 50% of max profit.) Therefore, we can use the Bayes’ Theorem in a slightly different way to think about how we might adjust a position and the power of short premium.

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