From the May 2013 issue of Futures Magazine • Subscribe!

Volatility-based support trading

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.   

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