History Shows It’s Time for a Trading Range
Mark Twain is alleged to have said, “history doesn’t repeat itself, but it often rhymes.” Historians don’t believe he actually said that, but the phrase has become a part of popular culture. That saying is widely quoted in politics and in the stock market.
In the stock market, history can be used to find trading strategies. Many traders will do this by testing historic data with various indicators looking for profitable trades. Once they find something that appears to work, they often optimize the parameters to find the one that worked best.
Optimization is the process of testing all possible combinations to find the single values that work best. For example, if you are testing the relative strength indicator, or RSI, you could test buying at all levels from 1 to 50. You may find that 41 works best over the past ten years.
If you were to trade with that value, you would be trading on the best results of the past ten years. But, in the next ten years, or even the next year, the best value to use is likely to be different.
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This process of optimization is often employed but rarely, if ever, succeeds. The problem with optimization is that the future is never exactly like the past. Remember, history doesn’t repeat itself, but it often rhymes.”
General Patterns Could Be Better Than Specific Patterns
That saying holds a wealth of wisdom for traders. If history is like to rhyme, that means it will unfold in generally the same way. This means that traders may find it is generally more profitable to trade broad trends rather than specific and targeted levels.
For example, using RSI, the goal might be to find deeply oversold stocks expecting them to rebound in a short amount of time. The general pattern would be to trade for a quick bounce. The general rules could be to buy when RSI falls below 5 which will indicate a deeply oversold extreme.
Selling should then be driven by the general pattern used to identify the buy point. Since the idea is to profit from a quick bounce, the trade could be closed after it is open for five days. This quantifies the word “quick” in the pattern and provides a complete trading system.
Of course, the system could be more specific. Traders could sell when RSI moves above 50 in addition to selling based on time. This would prevent giving back profits if the stock rallies and then sells off again.
Notice that each of the rules in that example are in general terms. But, they can be used to identify specific actions. The rules are applied to SPDR S&P 500 ETF (NYSE: SPY) in the chart below. The blue arrows indicate there were two trades, both winners, in the past 90 days.
This is a short term strategy and both of these trades were open just one day. They were both closed with a gain the day after they were opened because RSI moved from below 5 to above 50 in one day.
Charts could also be used to find general patterns that are specific to a stock.
A Chart Based Trading Strategy
Below is a chart of Microsoft Corporation (Nasdaq: MSFT). It covers the last year. Earnings reports are highlighted by blue arrows.
From this chart, we can see a general trend. The stock seems to make a big move on the earnings announcement and then settle into a trading range. This is a pattern that is seen in many large cap stocks.
Large cap stocks tend to be followed by a number of Wall Street analysts. This means news from the company is quickly transmitted to all traders and the implications of the news are almost immediately priced into the stock. That explains the large moves and then the subsequent trading range while we await the next bit of news from the company.
Since earnings are only announced once every three months, we can assume that Microsoft is likely to remain in a relatively narrow trading range for at least several weeks.
One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Microsoft
For Microsoft, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, December 29.
The difference in the exercise prices of the calls or puts is equal to $1.50. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $150 less the premium received when the trade was opened.
Selling the options will generate $1.00 in income ($0.40 from the call and $0.60 from the put). Buying the options will cost $0.65 ($0.25 for the call and $0.40 for the put). This means opening the trade will result in a credit of $0.35, or $35 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.50) minus the premium received ($0.35). This is equal to $1.15, or $115 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $115 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.35 or $35 per contract.
The potential reward on the trade ($35) is 30% of the amount risked, a high potential return on investment for a trade that will be open for less than two months. If a trade like this is entered every two months, a small trader could quickly increase the amount of capital in their trading account.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.