Investing Strategies

The probability distributions we will derive can be applied to almost any investment strategy.  Some of the easier to understand strategies that we may focus on originally, include:
    buying a stock
    selling a stock short
    writing a covered call, and
    selling a cash secured put.

The probability distributions we will be deriving can just as easily be applied to more elaborate strategies, such as those described at Options Industry Council website.  In particular, we recommend:
Getting started
Strategy Index (Some very informative profit/loss charts), and
    Understanding the charts

Why Buying Options are Typically Gambles and Selling Options Are Investments
Most of the options strategies involve buying options which typically are more of a gamble than an investment.  We say this because without information about probabilities (which is the purpose of this experiment), it is reasonable to assume that the current price of a stock is the most likely price when the option expires (the no change assumption).  Based on this assumption, the return will be negative (the value of the option when it expires worthless, minus the premium paid for the option).  Similarly, under the no change assumption, selling options (where the strike price is the current price) will result in a gain of the premium and thus is an investment. 

But Selling Options Might be An Investment Under Some Circumstances
Of course, the no change assumption is not realistic and that is why we will be in a much better position to make wise investments (rather than gamble) if we can derive probability distributions. This is because the expected value computation consists of multiplying the probabilities of an possible outcomes, by the values of the outcomes, and summing over all outcomes.  The probabilities from the probability distributions that we will derive in this experiment can be multiplied by the value (profit) of any investment strategy to compute the expected values of the strategy.  This will enable investors (like yourself) to select the strategy with the highest expected value (relying on the law of large numbers for long term gains) or to select an investment strategy that is attractive from a short term perspective (e.g. has the greatest probability of a profit of more than a specified amount).


The Magic Formula Strategy
The probability distributions we will derive are useful for improving any investing strategy, such as the 'magic formula' strategy explained in The Little Book That Beats the Market

 

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