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Standard Deviation on Vertical Spreads


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Standard Deviation on Vertical Spreads

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  #1 (permalink)
Boise, ID / USA
 
 
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So this may be a stupid question.... on a spread such as an IC or Strangle, setting short strikes at about 16% OTM would equal 1 standard deviation.
On a Vertical Spread, does setting the one short strike at 32% also equate to 1 standard deviation? Since you retain the 68% ITM, I'm thinking you retain the same risk by shifting the risk from one side to the other?

Or is that not correct?

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linker33 View Post
So this may be a stupid question.... on a spread such as an IC or Strangle, setting short strikes at about 16% OTM would equal 1 standard deviation.
On a Vertical Spread, does setting the one short strike at 32% also equate to 1 standard deviation? Since you retain the 68% ITM, I'm thinking you retain the same risk by shifting the risk from one side to the other?

Or is that not correct?

Correct. Using the often times useful method of using delta to determine the ITM/OTM probabilities, a strangle or IC with short strikes at 16 delta would have +- 68% probability of being OTM. A vertical spread with short strike at 32 delta would also have +- 68% probability of being OTM.

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  #4 (permalink)
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Delta can under certain assumptions be seen as the probability or likelihood that an option will expire in-the-money. So a 20% delta call could be thought to have a 20% chance of expiring in-the-money.

This probability is highly theoretical. It is not a FACT about the options that will always be true. All it means is that if every assumption in the pricing model that has been used to formulate the delta turns out to be true, then the delta can be interpreted as the probability of expiring in-the-money, in some cases.

This is very unlikely to be the case consistently or even frequently. Volatility can be higher or lower than expected. Interest rates can move. Indeed, for some options where cost of carry or dividends are relevant, this interpretation of delta is even more precarious. Nevertheless, as a rule of thumb, option delta as the probability of expiring in-the-money is undoubtedly useful to know.

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