A Special Options Strategy

Trend and Volatility

Combining the stock or futures trend and options volatility gives new insight in Options Analysis.

by Jesse Chen, CPA

Quite often in options trading, either you become attached to a few spread strategies OR you end up "gambling" by just buying calls or puts.

No real methodology can be developed using either of these choices.

A steady and consistent trading income comes from a complete "game plan" when making options trades.

One such "game plan" or methodology involves using Trend and Volatility.

First you must find an underlying stock or future with a big options chain such as QQQ or MSFT.

The big options chains gives you more spread strategies to work with as well as better liquidity.

IDENTIFY THE TREND

Next, you need to use some basic Technical Analysis to find the trend of the underlying.

I have categorized the 30 day trend into five levels:

Way Up	+8% or greater
Up	+3% or greater
Neutral / Volatile*	between +3% and - 3%
Down	-3% or less
Way Down	-8% or less

*Volatile is a neutral trend with a Statistical Volatility (explained below) greater than 40%.

These percentages and time frame are what I'm using right now based on the stocks / futures that I am analyzing and the

current market conditions. You can tweak these numbers to fit your trading style.

RANK THE IMPLIED VOLATILITY

Once you have identified the underlying trend, you must determine the Implied Volatility of

the at the money call and put options. Implied Volatility (IV) measures the option actual price

in relation to its theoretical price. The higher the IV, the more overvalued the option and vice versa.

In order to determine IV, you must first calculate the Statistical Volatility (SV) of the underlying stock or futures

historical prices. Statistical Volatility is the: (square root of 253<no. of annualized trading days>) X (the standard deviation)

IV can be calculated using any decent options software product such as OptionStar http://www.optionstar.com

Or you can find free online IV and theoretical price calculators searching on the web

such as http://www.warp9.org/nwsoft/bscholes.html .

Once you have found the SV the stock and the IV of the option, you can determine rank the IV using the following table:

High IV (Expensive option)	IV > SV by +25%
Mid IV (Neutral option)	<in between>
Low IV (Cheap option)	IV < SV by -10%

Again, these numbers are what I am using and can be adjusted to fit your trading style.

DETERMINE THE OPTIONS STRATEGY

Now that the Trend of the Underlying and the IV of the option are known, we can use

the following matrixes to determine the best options spread strategy.

TREND	HIGH IV (Call atm*)	MID IV (Call atm)	LOW IV (Call atm)
U - way up			buy call (bc)
u - up	covered call (bu+sc)	call debit (bc+soc)
N - neutral	short straddle/strangle (sc+sp)	ratio call (bc+2soc)*
V - volatile		ratio call backspread (2bc+sic)	straddle/strangle (bc+bp)
d - down	naked call (sc)	call credit (bc+sic)
D - way down

TREND	HIGH IV (Put atm)	MID IV (Put atm)	LOW IV (Put atm)
U - way up
u - up	naked put (sp)	put credit (bp+sip)
N - neutral	short straddle/strangle (sc+sp)	ratio put (bp+2sop)*
V - volatile		ratio put backspread (2bp+sip)	straddle/strangle (bc+bp)
d - down	covered put (su+sp)	put debit (bp+sop)
D - way down			buy put (bp)

* neutral 4 options spread is also recommended

abbreviations: bu - buy underlying su - sell underlying bc - buy call sc - sell call bp - buy put sp -sell put
i - in the money a - at the money o - out of the money atm - at the money

The matrixes sort the option spread strategies based on the assumption that the trend will continue.

For instance if the trend is Up, options spreads favoring up moves are used such as buying calls, put credits, and covered calls.

If the trend is Neutral, neutral options spreads such as short straddles, and ratios are used.

If the trend is Down, options spread favoring down moves are used such as buying puts, call debits, and selling calls.

EXAMPLES

On August 27, 2001 MSFT was trading at a $62 while the Sep 60 at the money Call and Put was

.8 and 5.5 respectively. This gives a call iv of 72% and put iv of 23%. The 30 day trend

was "way down" at -13%. The statistical volatility for MSFT was at 33%.

This would result in: trend - way down put iv - low

According to the matrix, the recommendation here would be to buy puts.

So we purchase the sep 60 puts for $.80

MSFT proceeds to plummet from $62 to $50 on Sep 21.

The Sep 60 puts go as high as $12 on Sep 21, giving 1200% max profit!

On June 29, 2001 IBM was trading at 113.35. Aug at the money put

option was 6 with an implied volatility of 28%.

This would result in: trend - volatile put iv - neutral

According the the matrix, the recommendation would be to buy a ratio put backspread (2bp + sip)

Resulting in buying two Aug 115p @ 6 and selling one Aug 125p @ 12 with a net spread cost of zero.

IBM drops as low as 102 on 7/10/01 where the spread could be closed as follows:

sell two Aug 115p @ 14 and buying back one Aug 125p $ 22 with a net spread credit of a 6 pt gain.

CONCLUSION

Using trend and volatility can be a sound options trading methodology.

The important thing is to adjust your percentages for determining

Trend and Volatility based on what your trading and your time frame.