SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Fat Tails and Option Returns


When it comes to calculating likely returns from option activity, traders contend with a variety of variations. Returns may be skewed (with declines in value more likely than increases), or unstable in many forms. Or the outcome might reveal itself in the form of a fat tail.

 

Fat tails can be graphed to show that tails are greater than normal distribution. On the well-known bell curve, probability of outcomes are most likely to occur at mid-range, with less likelihood in the tails, which are even on both sides. A fat tail graph shows that either declines or increases are higher than the expectation of this curve.
 

These fatter probability masses throw the entire theory into chaos, but it also reflects what often turns out to be the reality. It is comforting to believe that normal distribution will occur, but while it is likely, it is not always the case.


A fat tail may be subtle but important. The degree of change from normal distribution might be small, but in terms of net returns, it can significantly affect outcomes of trades. For example, the illustration shows how a set of fail tail distributions might appear. The normal distribution would be even on both sides, declining as the tails expand. In the fat tail version, the outcome reveals larger than normal losses (on the left) compared to normal profit distribution (on the right).
 

image.png


From the point of view of risk analysis, this type of distribution can help in identifying likely volatility on one side or the other. Volatility is best understood as the likely degree of change, but it does not identify whether that degree is going to increase or decrease price. It does identify the risk of change. Based on historical data for a particular underlying and its historical volatility, traders can equate fat tail analysis to likely option performance. Of course, this is all based on estimates of future volatility derived from the past.


A detailed analysis of how fat tail graphing works out in the real world would require many examples, and most traders do not have the automated tools to perform such detailed studies. It also raises the question of whether analysis of past price behavior is instructive enough to indicate a smart trade choice. In fact, it cannot be the case, because the past is only one pattern, but price distribution can take many forms and will be based on many, many factors. The occurrence of fat tails is more realistic than standard deviation, assuming a trader can rely on the proper side of the graph (positive or negative) and on whether all the mitigating factors are known and understood (they cannot be because there are potentially so many, and they do not apply in every situation).


An example of the unreliability of fat tail calculation can be found in analysis of earnings surprises. Traders are known to time trades based on assumptions about (a) whether surprises will occur and in which direction, (b) how large the difference will be between expected and actual earnings, and (c) the level of reaction for underlying and option prices.


Given the possibility that ‘a’ and ‘b’ are correctly estimated, the effect of ‘c’ cannot be known. An underlying security might experience identical earnings surprises in two consecutive quarters, both positive, and both about 10% above estimates. Even so, the underlying and option changes are different in each case. In the first of the two quarters, the underlying gains 6 points; in the second, it loses 2 points.


These differences occur for an infinite number of reasons. Investor and trader perception of value might have changed between the two periods. Management guidance about the coming year might be dissimilar as well. And finally, an unknown number of outside causes affect price in any given moment, so it is not realistic to expect the underlying or the options to behave in a similar manner.
 

In a perfect world, the distribution of returns would predict how option premium would change as the result of an earnings surprise. In the real world, this is not possible or reliable. Traders constantly seek some form of reassurance that with the right statistical tools and analysis, trade profits can be improved consistently. Everyone who has been trading for even a few months knows that this is not realistic. Too many factors are in play.


A bell curve for expected price behavior at the time of earnings reports could reflect how prices might respond to degrees of earnings surprises. This could be a revealing exercise, if a trader correctly predicts the degree of surprise and the direction (positive or negative). The normal distribution of the bell curve could then predict likely option premium reactions to the plotted level of surprise. However, many additional factors beyond the underlying will influence the reliability of this. These factors include bid/ask spread, time remaining to expiration for each option contract, moneyness of the strike selected, open interest, delta and gamma, and that “unknown” factor that causes some options to behave predictably, and others to reveal fat tail behavior.


The use of bell curves with either normal distribution or fat tails is also limited in usefulness. For studies of finite possible outcomes (such as whether a consumer will but product A, B or C), the study of distribution is reliable. For the analysis of option returns, there are simply too many possibilities, making it an infinite range of possibilities. In fact, analysis could even reveal that just about every option return will be found to have fat tails, because “normal” distribution is too vague to be applied with confidence.


In summary, when the outcomes are infinite (or at least appear to be), the fat tail analysis is not going to reveal much beyond guesswork. Some traders are infatuated with statistical analysis using fat tails and expected returns, but it simply is not possible to develop a consistent or reliable result. Even if you know in advance the exact direction and degree of an earnings surprise, there are still enough variables in play to make the probability analysis a poor method for picking and timing trades.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Real-time trade sharing: entry, exit, and adjustments

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe to SteadyOptions now and experience the full power of options trading!
Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • SPX Options vs. SPY Options: Which Should I Trade?

    Trading options on the S&P 500 is a popular way to make money on the index. There are several ways traders use this index, but two of the most popular are to trade options on SPX or SPY. One key difference between the two is that SPX options are based on the index, while SPY options are based on an exchange-traded fund (ETF) that tracks the index.

    By Mark Wolfinger,

    • 0 comments
    • 448 views
  • Yes, We Are Playing Not to Lose!

    There are many trading quotes from different traders/investors, but this one is one of my favorites: “In trading/investing it's not about how much you make, but how much you don't lose" - Bernard Baruch. At SteadyOptions, this has been one of our major goals in the last 12 years.

    By Kim,

    • 0 comments
    • 897 views
  • The Impact of Implied Volatility (IV) on Popular Options Trades

    You’ll often read that a given option trade is either vega positive (meaning that IV rising will help it and IV falling will hurt it) or vega negative (meaning IV falling will help and IV rising will hurt).   However, in fact many popular options spreads can be either vega positive or vega negative depending where where the stock price is relative to the spread strikes.  

    By Yowster,

    • 0 comments
    • 799 views
  • Please Follow Me Inside The Insiders

    The greatest joy in investing in options is when you are right on direction. It’s really hard to beat any return that is based on a correct options bet on the direction of a stock, which is why we spend much of our time poring over charts, historical analysis, Elliot waves, RSI and what not.

    By TrustyJules,

    • 0 comments
    • 478 views
  • Trading Earnings With Ratio Spread

    A 1x2 ratio spread with call options is created by selling one lower-strike call and buying two higher-strike calls. This strategy can be established for either a net credit or for a net debit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility.

    By TrustyJules,

    • 0 comments
    • 1,490 views
  • SteadyOptions 2023 - Year In Review

    2023 marks our 12th year as a public trading service. We closed 192 winners out of 282 trades (68.1% winning ratio). Our model portfolio produced 112.2% compounded gain on the whole account based on 10% allocation per trade. We had only one losing month and one essentially breakeven in 2023. 

    By Kim,

    • 0 comments
    • 5,901 views
  • Call And Put Backspreads Options Strategies

    A backspread is very bullish or very bearish strategy used to trade direction; ie a trader is betting that a stock will move quickly in one direction. Call Backspreads are used for trading up moves; put backspreads for down moves.

    By Chris Young,

    • 0 comments
    • 9,496 views
  • Long Put Option Strategy

    A long put option strategy is the purchase of a put option in the expectation of the underlying stock falling. It is Delta negative, Vega positive and Theta negative strategy. A long put is a single-leg, risk-defined, bearish options strategy. Buying a put option is a levered alternative to selling shares of stock short.

    By Chris Young,

    • 0 comments
    • 11,146 views
  • Long Call Option Strategy

    A long call option strategy is the purchase of a call option in the expectation of the underlying stock rising. It is Delta positive, Vega positive and Theta negative strategy. A long call is a single-leg, risk-defined, bullish options strategy. Buying a call option is a levered alternative to buying shares of stock.

    By Chris Young,

    • 0 comments
    • 11,527 views
  • What Is Delta Hedging?

    Delta hedging is an investing strategy that combines the purchase or sale of an option as well as an offsetting transaction in the underlying asset to reduce the risk of a directional move in the price of the option. When a position is delta-neutral, it will not rise or fall in value when the value of the underlying asset stays within certain bounds. 

    By Kim,

    • 0 comments
    • 9,671 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs