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