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Trading Declining Volatility

Trading Declining Volatility

Volatility is important to traders. Probably the most popular reason to believe high volatility is useful is because volatility can directly translate to significant price moves. Traders with exposure to stocks that make large price moves can make money quickly.

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  • Since large gains in a short amount of time is often the goal of traders, it stands to reason that many traders will want positions that benefit from high volatility. They may leverage volatility with options contracts, buying call options to benefit from price and buying put options to benefit from price declines.

    There is a less understood way to benefit from volatility. That is to search for stocks whose volatility is declining and sell volatility as it begins to decline. This strategy is also attractive from a logical perspective. It is also relatively simple to implement. Options can be sold to benefit from the collapse in volatility.

    The problem is defining when volatility is high or low. Many traders look at volatility indicators and spot highs or lows in hindsight. They may do this with one of the many indicators that are designed to measure volatility. VIX is the most popular volatility indicator but that applies solely to the S&P 500 index.

    VIX can be useful but there will be times when the volatility of an individual stock diverges from the volatility of the overall market. This means traders should use a volatility indicator based on the stock they want to trade rather than a broad market indicator of volatility.

    For individual stocks, one of the most popular volatility indicators is the average true range (ATR). Other popular volatility indicators include implied volatility and historical volatility which are calculated in some data services. Bollinger Bands and the Bollinger BandWidth indicator derived from the Bands also measure volatility.

    No matter which indicator is selected, the general process described in this article can be applied. To illustrate that process we will use the ATR.

    As its name implies, this indicator is an average of the true range (TR), an indicator developed to correct a problem with the range calculation. A stock’s price range is defined as the difference below the high and low price for a day. This calculation works fine most of the time but if a stock gaps up or down at the open, the range calculation will miss the volatility at the open. The TR corrects that problem.

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  • The TR is the largest value of three values that need to be calculated each day. Those values are the current high minus the current low; the absolute value of the current high less the previous close; or the absolute value of the current low less the previous close. This includes the effect of gaps. The ATR is a moving average (MA) of the TR.

    ATR measures volatility. It will increase in value when the stock’s price move are larger than they have been in the recent past. ATR will decline in value when a stock’s volatility declines and the values of the TRs become smaller as they would if the stock fell into a trading range.

    While ATR measures volatility, we don’t really know if volatility is high or low. Many traders look at the ATR and visually determine whether the value is high or low. This will lead to errors because a high value can continue moving up. A more quantitative approach can also be applied.

    To determine whether the current value of the indicator is high or low, an MA can be applied to the indicator. The MA shows where the indicator has been valued in the recent past. If the current value of the ATR is above its MA, volatility can simply be defined as high. Low volatility can then be defined as those times when the ATR is below its MA.

    Trading Based on ATR

    Options offer a variety of strategies that are suitable for trading volatility. Before finding a strategy, we will find a stock. Searching for stocks with declining volatility, we identified stocks whose ATR had fallen below the MA of ATR. This is a stock with declining volatility.

    Below is a chart of United Continental Holdings, Inc. (NYSE: UAL). The ATR is calculated over the past 22 days, which is approximately one month. The MA is calculated with 10 days of data. This MA was used because we are looking for a short term trading candidate and short term indicators should be used for that search.

    When volatility declines, we expect the stock price to remain within a relatively narrow range. One option 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 which is taken from The Options Industry Council web site.

    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

    For UAL, the trade can be opened using the following four options contracts:

    • Sell UAL July 21 $81 Call at $0.80
    • Buy UAL July 21 $82 Call at $0.58
    • Sell UAL July 21 $73.50 Put at $0.62
    • Buy UAL July 21 $72.50 Put at $0.52

    UAL closed at $76.92 on Tuesday.  The exercise prices of the calls are above that price. The exercise prices of the puts are below that price.

    Notice that all of the options expire on the same day. The difference in the exercise prices of the calls or puts is equal to $1. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.

    Selling the options will generate $1.42 in income ($0.80 from the call and $0.62 from the put). Buying the options will cost $1.10 ($0.58 for the call and $0.52 for the put). This means opening the trade will result in a credit of $0.32, or $32 for each contract since each contract covers 100 shares. That is before commissions are considered but commissions should be small at a deep discount broker.

    The maximum risk on the trade is $0.68, or $68 since each contract covers 100 shares. Most brokers will require a margin deposit equal to the amount of risk. That means this trade will require just $68 in capital.

    The potential reward on the trade ($32) is 47% of the amount risked, a high potential return on investment. The trade will be open for less than two weeks. If a trade like this is entered every two weeks, a small trader could quickly increase the amount of capital in their trading account.

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