A probability cone uses historical option data and a proprietary statistical formula in order to the graph the potential future range for stock prices. Your selection of the probability increment determines the number of arcs displayed on the graph. There is a trade-off between having a narrow range of expected price movement and a high probability of that event. High probability arcs cover the widest range of potential stock prices, while the lower probability arcs cover a narrow potential range of stock prices.
For example, using the default settings with a 20% probability increment 4arcs are displayed on the graph. The outer most arc (yellow) represents the price range where you might expect 80% of probable future prices to occur. The red arc would represent where 60% of future prices are expected to occur, and so on.
Probability Cone in Practice
Vertical lines are also present on the chart to represent the option expiration dates. This allows you to combine the knowledge of an expected price range based on statistical data with time series data to estimate the probability that your option trade has the potential to be in the money by expiration and theoretically its value.
For example, if we look at an option two expirations from now we can see that the there is an 80% chance the price of the stock at expiration would be between $44 and $40. Option buyers with the intention of holding until expiration would typically want to avoid buying strike prices outside of the indicated range due to the high likelihood they would expire worthless. Conversely, those traders looking to sell options would find it to their benefit to sell options outside of the indicated range.
Read Next: Probability Envelope
Related Indicator: Probability Envelope Comparison
The analytical tools described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to engage in a specific investment, tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances and investment objectives. Securities are subject to market fluctuation and may lose value. Market volatility, volume, and system availability may impact account access and trade execution.