Sunday, August 30, 2009

Statistics! You’ve got to be Kidding

My college roommate used to joke around and say: “I liked the class so much I took it twice!” At least I always thought it was a joke.

Every semester my final exams would get stacked up on the first 3 days of the week. It made the cramming harder, but it was nice to get it over with and go home early. However, my junior year was different I had one exam each day of the week. My last final “Statistics” was scheduled for Friday. I went to the testing center at the usual time to take the 4 hour exam. During the exam everything was going great I felt I was doing well when 1.5 hours into the test I heard the PA systems crackle and a recording announce: “the Testing Center will be closing in 15 minutes.” What! 15 minutes! I didn’t even think to check when the center closed, because it had closed at 9:00 PM all week. Talk about your major 'opps' there sports fans.

I explained what happened to the professor, but he wouldn’t let me retake the final even in his office. Blast! Failing the final gave me a C- in the class, so you guessed it… I liked the class so much I took it twice! The upside was that I aced the class the second time around, and the GPA boost helped me get accepted into the School of Business Management program. I also learned something from the "classes" that I use today, which is that statistical probability is a powerful ally to have on your side.

Okay so just how do you determine the probability of an option contract? With the help of online calculators it’s quite easy. To illustrate I’ll run the numbers for our current top trade candidate which is Caterpillar (CAT).

First go to the Optionistics probability calculator at:

Then fill-in the following fields:

  1. Symbol = CAT. Now click 'Load Data for Symbol'
  2. Lower Bound = 44 (this is the Put strike price under consideration).
  3. Upper Bound = 0 (we don’t need an upper bound, but I always enter zero which makes the results easier to read)
  4. All of the other fields are entered for you. Now click ‘Compute’.

The results show that as of today (21 days to expiration day) CAT has a 70.6% of closing above our Put strike price of $44. The probability will change each day as two variables 'stock price' and 'volatility' change. The one constant 'Time' works on our side. With each passing day the odds increase in our favor as we near the expiration date! This is also called time decay and it works against the buyer of an option and for the seller (us). Give the probability calculator a whirl on a few stocks, you'll see it's really easy.

Oh you might have one other question. Why did I choose the $44 strike price? Two reasons really $44 is at Caterpillar's near-term support level and the premium for the $44 option gets us above our 2% or more profit target. Getting the hang of this?

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