The next step is to perform a volatility analysis of the
trade. The importance of volatility analysis is critical to load the investing
dice in your favor. Most successful traders build their option trades
based on the volatility analysis. When you are trying to predict
the direction of the stock it is always a 50/50 game, unless you have some
inside information. Stocks can go North or South without paying attention
to the predictions of the "experts." The "experts" may be saying
that this stock has reached it "Support" or "Resistance" level and should
turn in the opposite direction. How many times you heard these type of
"predictions" and the stock continue in the same direction?
"Volatility" is different. When volatility reaches the
extreme level for a particular stock, it is more likely that it will reverse
itself. This pattern in volatility behavior is widely used to determine
which stock to analyze and what option strategy to use.
To analyze volatility behavior for the underlying, click
on the "Technical Analysis" button (top row of screen, 2nd button from the right). A small window will pop up, select
"Volatility History Indicator" and click on "Show Graph" button. "Volatility
History Graph" for Spyglass, Inc. will appear on your screen (see below). The chart has two sections. The top section contains a
chart of "400 Days" of historical stock data. The bottom section has two
historical charts of "1 Day Implied Volatility" and "20 Day Statistical
Volatility". If you look at the "20 Day Statistical Volatility" graph (blue
line), you will clearly see the pattern we discussed above. Volatility
was growing to the extreme level, then remained at this level for some
time before turning in the opposite direction.
Lets look where we are right now. Near the bottom of the display, there are two numbers highlighted in red and blue. The red number is the 1-day Implied Volatility and the blue number is the 20-day Statistical (historic) Volatility. These numbers can be used as guides on the above chart. To the lower right of the screen are two small windows labeled "line1" and "line2". To make it clearer, 163 was entered (value of "1 Day Implied Volatility") into Line 1 field and 263 (value of "20 Day Statistical Volatility") into Line 2. We then hit the "Apply" button to draw two horizontal lines at these levels. You can see that the current levels for both Volatilities are among the highest readings for these volatilities in the last 400 trading days. What
does this show? It tells us that volatility's are reaching their
extremes and ready to reverse.
Now what will happen with the "Probability of Success"
and the "Exp. P/L", if Volatility shrinks? It will increase both of them,
because it will be less probable that the price of the stock will move
beyond the breaking point of $33.50.
You should also analyze the worst
case scenario. The worst case is if the prediction about volatility direction is
wrong and it does not shrink. To check what would happen in this case,
click on the "volatility" button and select "Use 20 Day Stat. Vol. for
Target". Then click the "Compute" button. See below to review the
new calculations. The "Probability of Profit" became slightly less than
57.64%, but greater than 50%, and "Exp. P/L" shrunk to $0.4056, but is
still greater than 0. Even in the worst case scenario we have a pretty
good chances to succeed.
As you probably know or at least have seen from this example that "Credit Spreads" are directional
trades. You have to be at least modestly Bullish on a stock
to go with a "Put Credit Spread" and at least modestly Bearish to go with a "Call
Credit Spread".
If we take a look at a historical chart for Spyglass Inc.,
we will see that this stock recently went through a serious correction
and now we can reasonable assume, either a start recovery process or, because
of our volatility prediction, may be moving sideways.
It is hard to quantify our last "reasonable assumption",
because it is very hard to predict the direction of the stock movements.
On an other hand, our Volatility based analysis of this trade,
gives pretty good reasons to believe that this might be a good trade to
take. Again, the main purpose is not to tell you, which trade to take,
but rather how to create and analyze it. If you give a hungry person
a fish, you will feed him once, but if you teach him how to fish, you will
feed him for life!
There are numerous newsletters that you can subscribe
to. Never take their advice and put your money on the line without further
analysis. Take their recommendations, plug them into PowerAnalyzer and
do your homework. Be sure to analyze all aspects of the trade. Perform
the "what if" analysis, and if everything continues to look positive, make
the trade.
There is nothing wrong with listening to someone else's
advice. The error is made when people blindly follow the advice without
performing any research. If you do not want to analyze the trade
you are putting your money in, our recommendation is to put your money
into a Mutual Fund and let somebody else professionally managed it for
you. Conclusion The following summary actions, to effectively analyze
your trade, should be accomplished, before you invest your
money.
You will also see how your trading will change. Many PowerAnalyzer
clients state that their trading became less stressful because they analyzed
all possibilities and anticipated in potential surprises in advance.
They became more confident in the decisions they were making and
the trades they were taking. Many of them even developed their own successful
trading systems, as they learned more and more about option trading, because
the learning process with PowerAnalyzer is easy and really FUN!
Technical Analysis Tools
The above example used one of the Technical Analysis Tools – the
volatility chart of SPYG. In reality there are a number of technical
analysis tools that are available from PowerAnalyzer. If you have a
stock’s data already loaded, then you can click on the "technical analysis
tools" button (top row, 2nd from right). When you do that, a small window
appears with a drop-down menu. Click on the down arrow and you will see the following choices. If you
click on one of those choices, you will invariably be offered further
choices on how you want to plot the technical indicator you’ve selected.
After you have made all of your selections, click on "show graph". A brief
description follows each one of the indicators listed below. Note:
each plot also includes a chart of the underlying stock. The plot you
request is generally shown below the price chart (except for moving
averages and Bollinger Bands, which are drawn on the price chart. In those
two cases the stock’s volume history is shown beneath the price chart).
Volatility Ratio – plot a ratio of statistical vs. implied volatility, using the number of days of your choice. For example, you might want to plot 1-day Implied vs. 20-day Historical
Volatility History – as shown above, plot a graph of the volatility history of any two volatilities you want
Moving Average – plot any two moving averages on the graph of the stock. The stock’s volume is shown also.
Stochastic Oscillator – plot any two stochastic oscillators. .
Price Oscillator – plot the ratio of any two simple or exponential moving averages.
Price Rate of Change – plot the rate of change of a stock, over a user-selected time period.
Bollinger Bands – plot the Bollinger bands on a graph of the stock. Stock volume is shown below the price chart. Further Comments on the
Technical Analysis Tools
Once you have the desired chart showing, you can zoom in or zoom out, or identify any particular point. Left click anywhere on the graph and you will see a vertical bar appear. The exact readings for the day you have clicked on are then shown in the small boxes on the right side of the graph. And the values of the items you are plotting are shown, for that same date, in the red and blue boxes at the bottom of the graph.
You can plot two horizontal lines is you wish (as was done in the volatility example above) by filling in the two boxes entitled "line 1" and "line 2."
Finally, you can zoom in by left clicking your mouse and dragging over the portion you want to see. You can also do the same thing manually by changing the dates shown at the top of the screen and then clicking on "Zoom in". Click "Zoom out" to restore the original graph.
You can find more information on how to take advantage
of this volatility pattern, as well as how to become an expert in Covered
Calls, Straddles, High Probability Credit Spread plus many others in
different resources available from this
site.
1. Enter your symbol into "Symbol" field and click "Get
Data" button
These 10 Steps are the MINIMUM amount of homework that MUST
be done in order for you to make a wise decision. As you become more proficient
with PowerAnalyzer it will take you less and less time to complete these
10 Steps.
2. Click on "Select Your Tools Here" drop down window
and select "Show Strategy on Exp. Date"
3. Select strategies you want to analyze and click on
"Find Strategy" button
4. Sort results by "Exp. P/L" (default) or "Probability"
and find the ones that satisfied your selection criterions. If you did
not find any, go to Step 1, otherwise click on a first one, it will appear
in the Option Matrix, and then click on the "Compute" button
5. Analyze results in a "Price/Profit/Prob" Table or
click on the "Profit/Loss Graph" button to see a chart
6. Click on "Technical Analysis Tools" and select the
"Volatility History" graph
7. Analyze the graph and try to predict where volatility
is heading
8. Change the "Use Volatility for Target" field and compute
again to analyze "Best and Worst" cases scenarios
9. Change "Target Date" and compute again in order to play "what if"
analysis to find out what you can expect on a certain days before Expiration
10. Make your decision with this trade and go to Step
4 to analyze other strategies.