The expected range of a stock or index is the magnitude of the potential changes higher or lower from its current price. We also consider the probability of the stock staying within or exceeding that range by some future date, and base trades on that number. Theoretically, the price of a stock, ETF, index, bond or future can range from $0 to infinitely high. 100% of the time, the price of the stock will be in that $0 to infinite range.
As traders, what we’re interested is the probability of a narrower range of prices, or what the upper and lower edges of the expected range for a given probability. The expected range is calculated with a formula and is based on the current price of the stock, its volatility and the number of days in the future through which we would hold the trade.
Generally, we break down the expected range into different levels of probability, 68%, 95% and 99%, which correspond to 1, 2 and 3 standard deviations respectively. So, if a stock has a 68% probability of staying inside the upper and lower ends of an expected range, then there is a 32% probability that the stock will exceed that expected range. The reason is that the stock will be between $0 and infinity 100% of the time, so if there is a 68% probability of being inside some range inside of $0 and infinity, then there is a 32% probability of being either below the lower end of the range or above the upper end of the range.
At tastylive, we base our option strategies on those numbers, and look to sell options at strikes that the are either at or outside the expected range of the stock. If we sell a call and a put at strikes corresponding to the upper and lower ends of the range, that strategy would have an approximately 68% probability of making money, and a 32% probability of losing money. Knowing the probability of a stock staying inside or exceeding its expected range gives us a certain level of confidence in our strategies.
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