Hi option traders. I hope you’re having a great day. In this article I want to discuss standard deviations and probabilities as they are calculated by the popular options analytical software that is on the market. In the video that is attached to this article we are using software by Think or Swim. This is one of the most popular software programs in the world. It has a built-in feature to help us calculate probability of complex option strategies, but there is one thing missing when we use this feature. The software does not consider the current trend of the underlying that is being analyzed. Instead, the software always assumes that the underlying is trending sideways.

The technical traders out there know that these patterns and trends with technical analysis are pretty consistent. When we are looking at standard deviation charts, and we are using software to calculate probabilities, the software does not know the current trend. It is assuming that we are just going sideways. It’s assuming that there’s an equal chance for that object to fall to the left or to the right. But when it comes to trading options, it’s not like that because we do have patterns.

Let’s consider a real trading example. If RUT is trending down and we set the standard deviation at the money, then the software might give us a probability of 79% for an Iron Condor. However, if the market is really in a down trend, is this probability really accurate? What do you think the correct probability is on this trade?

This Iron Condor strategy is very popular in the options trading community, and one reason is because everybody thinks it has a very high probability. But the truth is the probability on this trade is not near as high as we think it is. The reason being that the market does not trend sideways for very long. In fact, if you look at a price chart, you will see that the market normally trends up or it trends down. This makes the probability of an ATM Condor much lower than it appears to be.

Let’s think about the rain. When rain falls from the sky, does it always lands on a perfectly flat and level surface? If it does, then the calculations of probability by placing the standard deviation at the money would be correct. However, consider this. What if the rain drop land on a slanted hill? If this is the case then most likely the water will splash downhill and not uphill. Now if you look at this video, you will see that this Condor appears to have a very high probability, but if we move the standard deviation to the left because we are in a bearish market, then the probability is substantially lower. In fact it might only be about 45%. We are just estimating here, but it’s important that you understand the concept.

Every experienced trader knows that the market normally trends in a direction, making the probability of the Iron Condor not as high as we believe. Those of us who believe in technical analysis should find a way to calculate probability using the trend combined with standard deviations. This would give us a more accurate analysis of the trade. As a final example, a bearish trade will actually have a higher probability in a bearish market than it appears to have in the options analytical software.

I will finish by saying that maybe we should really ask the question: what factors should we include in our calculation when we analyze the probability of an option trade? Should we throw technical analysis out the window and always assume that there is an equal chance for the stock market to go up or down at any given time? When it rains, how often do rain drops land on a perfectly flat and level surface? Do they ever?

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