The Skinny On Options Data Science

Outlier Detection

The Skinny On Options Data Science

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

Outliers is a term used by financial professionals and we sometimes use the word on tastytrade. It refers to data points, such as prices, percentage moves, Implied Volatility (IV) levels, that are “far away” from other values. How can we find outliers? What is an outlier move in stocks? The head of our research team, Michael Rechenthin, Ph.D., aka Dr. Data, joins the guys to use the tools of Data Science to explain these things.

The standard bell curve is often used to explain the term of Standard Deviation (SD). One SD will encompass 68% of data events. Two SD is 95%. Three is 99.7%. Our rule of thumb for an outlier is more than 3 SD. All of this though is based upon a “normal” distribution curve. Premium sellers soon realize that there is Volatility Skew. This is because market returns tend to be skewed to the downside, or simply put, large declines occur much more often than large advances. According to theory, two SD moves should only occur once per month but happen twice. Three SD moves should only occur once per year but happen 6 times. Four SD moves should only occur once every 40 years but there have been 76 such occurrences in that time frame. Five SD moves should only occur once every 5000 years yet there have been 37 such occurrences over just the last 40 years. Those ignoring our advice to “stay small” can easily get knocked out of the trading world.

Mike displayed a scatter plot chart to demonstrate that the 8% up move we have seen since the election is not unusual. Ninety five percent of 45 day periods have fallen in a band of between up about 11% and down about 17%. A skewed distribution curve was used to add the information that 90% of 45 day moves were between +8% and -4% and that 99% of 45 day moves were between +16% and -25%. Some might see this as a reason to buy cheap options. Dr. Data recommended against that and reminded everyone of the February 18, 2016 segment of Skinny on Options Data Science, “Buying Cheap Options” which explained why traders should not do so.

Watch this thoroughly engaging segment of Skinny on Options Data Science with Tom Sosnoff, Tony Battista and tastytrade’s research team leader Michael Rechenthin, Ph.D., for an in-depth look into stock market price move outliers and how often they really occur.

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