Profit/Loss on options are generally skewed.
Dr. Data (Michael Rechenthin, Ph.D.) explains how outliers can skew the averages and distribution curve of profit and loss and sometimes produce misleading results. A better understanding of this should help and enhance your trading.
The average and the standard deviation (SD) can be used to describe the data if we have a normal distribution. As tastylivers though, our profits occur more frequently than our losses but are smaller. This skews the data and can be misleading. As an example, Warren Buffett lives in Omaha NE. The average net worth of a resident of Omaha is skewed by the tens of billions of dollars that Buffett is worth. Removing Buffett from the equation produces a more meaningful mean average.
The same holds for trading results. Relying upon the average and standard deviation to explain past results can be misleading and unclear. The 5-number summary (a stats term) is introduced here as an alternative.
A slide showing the average P/L and the percentage profitable at expiration of strangles and straddles was shown. Going by the average one would always choose a strangle. A slide showing strangle performance was shown with profit and losses plotted. The average profit is $600 but removing the outliers from 2008 it is $900. For straddles the average is $800 but when removing the outliers it is $1500
The five number summary accounts for outliers. The first step is sorting the data from high to low. A slide shows the 5 different data points and how to do this using a set of hypothetical P/L results. Dr. Data explained the concept and elucidated on it. Another slide showed the five data summary using real data from SPX strangles and straddles since 2005 and Dr. Data provided commentary.
Takeaways:
When we have skewed data, the average and standard deviation are not very relevant
The 5-number summary gives us a better feel for the data, allowing us to make more informed decisions
Watch this segment of “The Skinny on Options Data Science” with Tom Sosnoff, Tony Battista and Dr. Data to learn how outliers can skew the results and produce misleading averages and how to use the five number summary to see through the misleading averages.
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