A probability envelope uses historical option data and a proprietary statistical formula in order to graph the potential range of future stock prices. The range defines where stock prices are likely to be within a specific period of time. By default the expected range is set to 68% (similar to two standard deviations).
Probability Envelope in Practice
The probability envelope displays an arc which is created based on user define inputs. 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 68% chance the price of the stock at expiration would be between $44 and $42. 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 Comparison
Related Indicator: Probability Cone
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.