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Volatility, Bollinger Bands, And The Yen
Combine
volatility with your favorite trading signal, and your trade will
become a whole lot easier. Here’s an example using the yen.
By Matt
Blackman
Traders
are taught from the beginning that acting on a single signal to
generate a trade is a risky, regardless of the asset class or time
frame: Which signal will you use to do so?
Not only
that, relying on different indicators that use the same datapoints
may seem sufficient to uninitiated, but that provides a false sense
of security. Relying on two indicators that use the same
permutations of high, low, open and close for confirmation is like
expecting a three-dimensional image by looking at two television
screens at once. All you get is the same image in duplicate.
“Using
indicators that are not correlated or, at best, have a very low
correlation with one another is a far more effective approach for
giving traders more confidence in signals that agree,” points out
Darrell Jobman, editor in chief at www.TradingEducation.com.
“These
kinds of signals are truly two dimensional because they rely on
different data.”
VOLATILITY OF THE THIRD KIND
Price is obviously the base for indicators used by most traders, but
one non-correlated data source is volatility, one of the
least-understood concepts for traders. Volatility has one
characteristic that makes it more predictable: Unlike price, which
does not have a set rhythm, volatility is highly cyclical. Like the
calm before a storm, periods of low volatility are inevitably
followed by a volatility expansion and a price breakout. For most
traders, the difficulty lies in knowing which direction this will
occur.
The
options trader relies heavily on the concept of volatility. In fact,
John Bollinger, creator of his namesake bands that describe and
track price volatility, was originally an options trader. Bollinger
Bands contain price action by a set number (usually two) of standard
deviations from a simple moving average that help the trader
determine when volatility has reached extremes.
Bollinger’s understanding of options no doubt played an important
role in developing his Squeeze and Bulge plays. The Squeeze occurs
at six-month low volatility when his bands are at a minimum distance
apart for a 125-trading day period. The Bulge trade is made at
six-month high-volatility periods when his bands are at their widest
distance apart in 125 days.
Bollinger Squeezes often warn of times when the probability of
breakouts or reversals is higher and when volatility is higher.
Bollinger Bulges warn that a lower-volatility period of
consolidation is more likely (see Figure 1).
Figure 1: BOLLINGER BANDS PROVIDE A PICTURE OF
VOLATILITY. When Bollinger Bands
narrow or “squeeze,” note the breakout action that often follows.
When they widen or “bulge,” note how market action consolidates
after the high-volatility period.
KEY TO OPTIONS
PRICING
Volatility is important to options traders because when
volatility is high, options are expensive; when it is low, they are
cheap. Historical volatility is a measure of how fast the price of
the underlying instrument has changed over a set period ranging from
days to years. Implied volatility is an estimation of what
volatility will be in the future. A comparison of the two determines
when volatility is at unusual levels.
When implied volatility increases, price often does as well in the
case of futures. In cases such as the Chicago Board Options
Exchange’s Volatility Index (VIX),
which allows traders to trade volatility directly, the reverse is
true, as extreme low levels are used to warn of market tops.
If
implied volatility is in the lower 5 percentile, the trader knows
that it is lower than it has been 95% of the time, and the option is
relatively cheap. If it is in the 75 percentile,
volatility is in the upper 25 percentile of where it has been
historically, and the option is quite expensive.
DIFFERENT
ANIMALS
Historical and implied volatilities are two very different, very
loosely linked quantities, according to John Bollinger. “It is best
to think of historical volatility as a physical characteristic of
the market, while implied volatility is a psychological
characteristic of traders/investors,” he explains. “The difference
can be most readily seen in the distributions of the two series.
Historical volatility more nearly approximates a normal
distribution, while implied volatility exhibits a very asymmetrical
distribution due to the differing psychological responses that
investors and traders exhibit to upside and downside price action.
“For example,” he continues, “while we
find spikes in historical volatility for both the upside and
downside price movement, implied volatility is very sensitive to
downside price action, but its response to positive price changes is
severely muted. There are times when the two are linked and the
relationship can be exploited, but more often the linkage is loose
or sometimes seemingly nonexistent.”
There is
a distinct difference between volatility as measured by Bollinger
Bands, which is determined strictly by price movement, and implied
volatility, which is set by a complicated measure that requires a
large number of iterative or consecutive calculations. But both can
be useful.
TIMING
COMMERCIALS
The Bollinger Band view of implied volatility helps determine
when options premiums are either high or low. But according to
futures and options specialists, implied volatility can be used in
another way to help time trades.
“The
theoretical value of options inputs, like implied volatility, can be
a very powerful tool to see the bias of the biggest professional
traders writing premiums,” a specialists opines, adding that one of
the reasons that the public does not relate as astutely to selling a
market as the large commercial trader or money manager does is that
even though markets can drop twice as quickly as they rise, retail
traders are more reluctant to short the market than the pros.
“As
futures prices rally, volatility increases and with it the cost of
options because most of the purchasers are buying the calls and
bidding up the prices in something akin to a buying frenzy,” the
specialist points out. “When the price has moved up and the retail
traders have overbought calls, that is usually when the price
reverses. Those who have been writing the call options and have
bought the puts profit handsomely from either a slow or rapid drop
in call option premium and decreasing implied option volatility at
the same time put options are appreciating.”
The
converse is that implied volatility drops as price drops because the
retail trader is reluctant to short the market or buy puts that
profit from market drops. On a currency futures contract, the
volatility dropping from 9% to 8% as the value of the currency drops
means nothing to most retail traders.
But to
these specialists, it speaks volumes and means that those buying
calls are giving up as their call-buying frenzy is nearing
completion. When most of them have capitulated, reversals become
more likely. They wait for a buy signal from a moving average
crossover and a slight rise in implied option volatility – a change
from a low implied volatility to a rising implied volatility
environment that is further confirmation of the buy signal. If these
buy signs are accompanied by the break of a downtrend resistance
line and an increase in either open interest or volume, the
probability for a profitable outcome is increased.
Figure 2: CONFIRMING SIGNALS.
A moving average crossover provides the initial
buy signal, confirmed by a trendline break on a bullish candlestick
and rising implied volatility, a combination of analytical
techniques that can give a trader more confidence to take a trade.
A YEN TO BUY
A closer look at the Japanese yen futures chart provides an
example (Figure 2). The trading specialists were watching implied
volatility as yen futures dropped more than 9% between the beginning
of September and the end of November 2005. On September 30, implied
volatility was 8.2%. It slipped to 8.1% on October 28, then to 7.8%
on November 25.
By
December 9, however, it had jumped to 8.3%. This told the traders
that buyers had begun stepping up to the plate to buy call options
on the yen, which they interpreted as bullish, especially
considering the extended period of weakness.
It’s
always best to wait for confirmation from another dataset. I use a
crossover signal from moving averages. If you look at Figure 2, you
can see that at about the same time as when the buyers stepped in,
there was a five- and nine-day moving average crossover buy signal.
Options
implied volatility works as well as anything used previously, the
options specialists report. A buy signal was further confirmed by a
break of the downtrend line to the upside on December 12. The
specialist commented that when they saw implied volatility jump
after dropping for more than two months, it confirmed their chart
buying signals and gave them greater confidence to go long on
December 12 because the chance of being whipsawed out of the trade
was lower.
You
don’t have to be an options trader to use options intelligence to
improve your trading confidence, of course. You can combine some
measure of implied volatility provided by your broker or your
analytical software with your favorite trading signal, and you will
find that taking a trade not only becomes easier, your confidence in
the outcome will also increase.
Matt Blackman is a market analyst
for TradingEducation.com and a technical trader, author, reviewer
and keynote speaker. He is a member of Technical Securities
Analysts Association (TSAA)
and the Canadian Society of Technical Analysts (CSTA),
and a Market Technicians Association (MTA)
affiliate member. |
