Using a mathematical model (formula) can someone beat the market ?
The answer is: no
Only the optimistic think they can .
What a mathematical model can do, is predict risk of a given event ,with certain accuracy
Premiums and policies are based on this principle , using a mathematical model they can predict the risk when given the right information
Insurance companies do not know when an accident will happen or when a person will die they only know the probability of happening
Same with stocks
if a model is used to reduce risk then it becomes an extremely valuable tool.
Now ,let's talk about History
Carl Friedrich Gauss , German Mathematician ( 1777-1855) is the creator of the so called distribution curve, known as the probability curve or the Bell curve
A Bell curve is a standard procedure for defining probabilities
The curve has the shape of a bell, it is symmetrical and in the horizontal axis measures standard deviations 1 , 2 , 3 -1 , -2 , -3
Std. dev. is one a very useful and rather simple mathematical concepts but good explanations are hard to find
To be honest Std. Dev. is a more difficult concept , but that does not mean it has to be ignored
Perhaps a good start is by asking What is a deviation ?
Simply put is a distance being measured from a point
And Standard ?
It means "normal" ," usual" , and it refers to PROBABILITY
One Standard Deviation the USUAL is a 68% Probable
Two Standard Deviations the USUAL is a 95 % Probable
In stocks IV is the value for One Standard Deviation , in one year , as time frame
The best way to explain is with examples and the simpler the better
Let's use 3 stocks with different IV
GOOG ATM IV @ 47.57 %
JNJ ATM IV @ 10.78 %
CAT ATM IV @ 27.80 %
What do these stocks have in common ?
The SAME probability which is 68%
And the difference ?
Each one has DIFFERENT distance
GOOG is 68 % PROBABLE that in a year
will move in a 47.57 % , range ( up or down )
JNJ is 68% PROBABLE that in a year
will move in a 10.78% , range ( up or down )
CAT is 68% PROBABLE that in a year
will move in a 27.80 %, range ( up or down)
What about if I want to know the 68% probable move for one day ?
Easy, do this IV x 0.0523
How did I get 0.0523 ?
Easy 0.0523 = Square Root ( 1 / 365 )
GOOG's ATM IV = 47.57 %One std. dev. for one day is 47.57% x 0.0523 = 2.48 %
This is useful specially when planning on putting a trade based on earnings released one day before options expiration