**Using statistics and
probability in Options Trading**

Professional gamblers prefer not to use the word "luck"

when evaluating their methods. Instead they choose

to say: "favorable return period" or "positive abberration".

That's because they see every game as a calculated

risk with all decisions based strictly on the best probability

of profit.

One must use the same "no nonsense" approach in evaluating options
trades

An effective way to evaluate any options trade is to gather

the following statistical information: maximum risk and reward,

probability of profit, expected return, and profit zone (breakeven points).

Maximum risk and reward

The first question one must ask when looking at an options trade is:

"What's the most I can make or lose on this trade"

These numbers can easily be calculated on a PL vs Price graph.

Here we build a call debit spread position for MSFT on 12/14/00. Microsoft is
trading at 57.688

The options are as follows:

buy 1 jan-01 47 call @ 12.125

sell 1 jan-01 50 call @ 9.750

From the table on the upper right corner, we see that them maximum reward for
this spread is $63 and the max risk is $(238).

As we observe from the PL graph, this position is profitable at any point above
48.97 with the max profit at 50.

The next question one would ask is "what are the chances that this will
be a profitable trade?"

We would review the probability of profit which shows 80.97%

Finally we would ask: "what is the projected return of this trade,
taking in to consideration: max risk / reward and probability?"

We would review the expected return which shows $5.

Expected return is calculated as: (max reward x probability of profit) + (max
risk x probability of loss)

Finally we would want to see are are profit zone on this trade in relation to the price history of the stock:

As we can see, this spread is profitable at any price above 48.97 (yellow
line).

The 90 price history (blue line) of the stock has consistently been well above
this point.

Now lets review the statistics and probabilty for a ratio call spread.

Here we build a ratio call spread position for MSFT on 12/14/00. Microsoft is
trading at 57.688

The options are as follows:

buy 1 jan-01 57 call @ 4.875

sell 2 jan-01 60 call @ 3.500

Let's review the statisical information on the table in the upper right
corner.

This ratio spread has a max reward at $359 and an unlimited risk.

As we see from the PL graph, this spread is profitable if MSFT stays below
65.12.

The probability of profit is 74.20% and the expected return shows an unlimited
risk.

From the net cost, we would receive $213 when we open this spread.

Next, we would review the Profit zone vs 90 day historical price chart.

We see from this position is profitable anywhere below 65.12 (yellow line).

The 90 historical prices have penetrated the profit zone from jul - sep and

during most of oct. It is currently well below it.

From these two spread examples we see how effective statistics and

probability can be in evaluating any spread.

**Copyright 2000 Star Research, Inc.
All rights reserved, no reproduction or re-transmission of this document is
permitted without express
permission from Star Research, Inc.**