Volatility-based support trading

April 23, 2013 07:00 PM

For more than 14 years, traders have been whipsawed back and forth by the stock market with little to show for it — except for mounting frustration and declining trading capital. Until recently, since the dot-com era went bust in March 1999, the market has traded with all the zest and enthusiasm of a lead balloon. It has made anemic attempts at bull runs only to roll over into steep price declines before re-starting this up-and-down pattern over and over again.

Sometimes for extended periods, price breakouts will fail with few real trends developing into any meaningful move as the market continues to trade sideways. Trading support and resistance levels would seem logical, even easy, to do in the current market environment, but as with most things in trading, this is easier talked about than put into practice.

One reason for this is the frequent failure of traditional tools for sideways markets. While conventional technical analysis may give you a glimpse into the mechanics behind these moves, if you can see them, then other traders can see them as well.

Human behavior & volatility

There are three market types: Up, down and sideways. Simply knowing you are in the midst of an extended sideways trading period doesn’t make the market easy to trade. In much the same way that market conditions have changed for trend trading and breakout trading, sideways markets have evolved and new methods have been needed to trade them effectively.

The goal is to develop a method that pinpoints optimal price levels for resistance and support, minus the unpredictability. To accomplish this, we need an approach that doesn’t rely on static points in an underlying security’s price action, but one that can reflect the dynamic and ever-changing state of the price action itself.

One reason for this might be that more traders identify the market as sideways. As a result, they have changed their trading approach to adapt, and static support and resistance price levels have become more volatile and less predictable. Static supports are relatively easy to identify by other traders and they become battlegrounds for bulls and bears who are attempting to seize control of price movement. The result is that price action tends to behave erratically, causing stop loss points to get stopped out before trades have a chance to profit.

Volatility tool

Often, price trades at extremes, becoming excessively oversold. When that happens, an imbalance occurs in which a correction is needed to restore order to the true value of a given security.

Bollinger bands, popularized by John Bollinger, measure volatility in the form of highness or lowness of the price relative to previous trades. The closer a security is to its lower level, the more oversold it is, and the closer a security is to its upper level, the more overbought it is.

Bollinger bands adjust themselves to the market conditions so, as a result, these bands can be used as dynamic support/resistance levels for the underlying price action. Volatility tends to revert to its mean, and after price trades at the outer edge of a given band, it tends to trade back toward the median level represented by the mid-line moving average.

Another helpful indicator is %b. The %b indicator is derived from Bollinger bands, and represents a security’s price in relation to its upper and lower Bollinger band. The %b indicator can be used to identify overbought and oversold situations within the framework of Bollinger bands. However, it is important to know when to look for overbought or oversold readings. As with indicators, it is best to look for short-term oversold situations when the primary trend is up, and short-term overbought situations when the primary trend is down.

There are six basic relationship levels between %b and Bollinger bands:

  • %b equals 1 when price is at the upper band
  • %b equals 0 when price is at the lower band
  • %b is above 1 when price is above the upper band
  • %b is below 0 when price is below the lower band
  • %b is above 0.50 when price is above the middle band (20-day simple moving average)
  • %b is below 0.50 when price is below the middle band (20-day simple moving average)

Method & madness

When the trend is strong and price is trading above the mid-line moving average in the Bollinger band, it rarely will dip below that mid-line in what Bollinger calls “walking the band.” This is where price trades with conviction in a given direction without pulling back toward the mean, represented by the mid-line. “Walking the band” (below) illustrates this methodology in the Dow Jones Industrial Average.

In strong trends, prices can walk up the upper or lower band and rarely touch the opposite band. However, when price travels too far above the upper-line of the Bollinger band, it reverts not just to the mean but tends to overcompensate by snapping back in the other direction.

This where the volatility-based support trade setup comes into play, taking advantage of this price phenomenon. These are the parameters:

  • Stock must be above $50 or higher.
  • The stock’s 20-day volume average must be at least 250,000 shares traded daily.
  • The stock must be trading above its 200-day simple moving average.
  • Set Bollinger bands at the 20,2 setting.
  • Set the %b indicator at the 5,1 setting.

Enter a long position when:

  • Price is trading above the mid-line of the Bollinger band and the %b indicator has a reading below -0.10; enter the following day if price trades above the intraday high.
  • Price is trading above the Bollinger band’s mid-line then trades below it while the %b reads -0.10 for two consecutive days; enter a long position as price trades above the previous intraday high.

Your exit is when the %b indicator closes above the 1.0 level. Alternatively, you can have an adjustable stop just under the Bollinger band’s mid-line moving average.

“Support trading scenarios for ALXN” and “ALXN walks the band #2” (below) present two examples of applying this methodology to Alexion Pharmaceuticals (ALXN).

Call options & directional trading

The beauty of this setup is not just that you are allowing an underlying security’s volatility to establish support rather than trading off static price points that every other trader also can see, but these moves materialize as short bursts or snap-backs from an oversold condition. This means that you can turn over more trades, more often, and that means more opportunities to put your money to work.

These qualities make this setup extremely effective when trading call options with a high percentage of winners. There are many benefits of using options here, but two are their superior leverage and relatively low risk.

When you buy an option, your risk is limited to the cost of the option itself rather than an entire stock position. Also, for every option that you purchase, you control 100 shares of stock, providing great leverage. For these reasons, it is worth exploring using options for volatility-based support level trades.

Consider this option-based approach, which builds on the rules detailed above:

1)      A long signal is triggered based on the rules above.

2)      Purchase the front month in-the-money call. You’ll want an option one to two strike prices in-the-money. So, if the stock is trading at $77 a share, then you want to buy the $70 call options. These strike prices are more likely to move in tandem with the stock’s price action, so if the stock trades up $1 after you take a position, then you should have earned $100 in profit, more or less.

3)      Exit on the signal above the %b’s 1.0 level, or your own pre-determined price target.

If the front month’s option has just seven days until expiration, then buy the next month out. For example, if the October calls have just seven days until expiration, then go ahead and buy the November calls instead. Similarly, if you purchase an option that is coming up on expiration while you are still in the position without an exit signal, then roll your call position over to the next month so you can retain exposure to the setup’s signal.

This setup can offer you a lot of trades, and you can trade it as conservatively or aggressively as you choose. If you’re conservative, then wait for the %b to register two consecutive days below -0.10. If you’re aggressive, then you can take the signals from the first setup condition where price is “walking the band” and the %b closes below the -0.10 reading as well as the second setup signals, or even add to your position at that time.

However you trade with this setup, you’ll be able to see the market with a different set of eyes by being able to rely on volatility and its relationship with price to help guide your decisions, giving you the edge in today’s hyper-competitive environment.   

About the Author

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.