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Increase the Probability of a Winning Trade Mike Batty

There are almost an unlimited number of opinions on technical

indicators. Entire careers have been spent on the analyses of
the meaning of technical indicators and how to better apply
them in relation to the stock market. At the beginning of my
trading career, I learned a simple dictum from a wise and
successful trader. My stock charts were awash in indicators.
I was worried that no matter which indicators I picked, if I left
others out, I might miss an important buy-sell signal. My
mentor told me to throw them all out, pick four from the pile,
and ask myself, “Can I make a buy or sell decision based on
what the indicator is telling me?” If the answer is “yes,” then
I ask myself, “Does the indicator give correct signals six out
of 10 times?”If the answer is “yes,” then I would keep it until
I come across one that works better. Since becoming familiar
with volatility, I never make a trade without considering it.
However, I had to eliminate an indicator I had been previously
using to keep my total number of technical indicators to four.

I first learned how to apply volatility (as it works best for me)
after reading a 2001 article by Ravi Kant Jain, titled Putting
Volatility to Work. In the article, Jain addresses historical and
implied volatility, and how they are calculated.
The information that was germane to my
trading was contained in a few simple
statements following all the math. In short, it
told me how to trade covered calls with the
combination of historical and implied volatility.
Very powerful stuff. For those of you who are
interested, the historical volatility (HV) formula is
calculated as follows:

(This formula by-passes the “mean” arguments in other HV for-

mulas. It is popular among traders because it more accurately
reflects expected results when a stock is trending.)

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Most of Jain’s article was interesting, impressive, and unfortunately, of zero worth. About three pages
in, I struck paydirt. In the article, Jain says that “the best candidates for covered call writing are stocks
with the biggest difference between implied versus historical volatility.” This is useful information.
I have no idea why Jain threw out that small piece of very simple information in the middle of what
I consider to be a fairly technical piece on volatility, but I was grateful. It has made my covered call
trades more profitable. Here is how I apply it to covered call trading.

It is universally accepted that stocks trade in a range that is normal for them. Each stock has its own
range, and outside that range it is behaving abnormally. Google (GOOG), for example, trades in
a range of around $18.50, To avoid a lot of academic discussion on how the average true range
(ATR)formula works, let’s just say that it is about $9.25 above a norm and $9.25 below. If GOOG
stays in that range for a protracted period of time, its volatility should not be considered outside its
normal behavior. If, however, the ATR for GOOG goes up to $35.00, its volatility shoots up on the
volatility chart as well. The stock is behaving in the extreme. Stocks do not live in the extreme. If they
did, it would not be extreme, it would be normal.

Research in Motion (RIMM) has an ATR of roughly $6.00. That is a swing of $3.00 to the upside
and $3.00 to the down side. Its volatility chart should be mid-point, if it does that for 30 days
(assuming the volatility chart is a 30-day chart). If RIMM suddenly starts swinging $5.00 to the
upside and $5.00 to the downside, its ATR is now $10.00. The result will be a higher set of values
for volatility.

In theory, neither GOOG nor RIMM will keep that extreme behavior. They will return to normal. That
means that if a stock has high historical volatility, the price should fall. What is a normal volatility?
Mid-point on the volatility chart. Anything above is, in theory, overpriced. Anything below is under-
priced. The further away from the midpoint of the chart, the greater the chance is that the stock price
will swing the opposite direction.

There are volatility indicators for stocks. What if we had a volatility indicator for options as well?
There are! It is implied volatility. Implied volatility is actually a projection of what we think the price
of the stock will do, but it is also, according to Jain, a surrogate indicator of what the option’s price
will do.

Think about this for a minute. If the historical volatility on a stock is down, well below the midpoint of
the volatility chart, the stock, in theory, is underpriced. This is a great time to buy the stock. If at the
same time, the implied volatility (surrogate indicator for the price of the option) is high, then the price
of the option is excessive. The option is overpriced. This is a great time to sell the option. That is a
perfect setup for a covered call. Buy cheap stock, and sell expensive options against it.

Volatility, unfortunately, has a mean streak. It does not care about trend. So assume you find a stock
where the volatility chart gives you low values on HV and high values on IV, and you make the trade.

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Because you are excited about playing volatility, you fail to check trend. You buy the stock
and sell the call against it (a covered call) only to realize that the stock is trading downward.
That is a terribly amateurish mistake. Only famous TV personalities can trade against the trend.
Then they talk the stock up and make money. So, unless you are a prime-time TV announcer,
do not trade against the trend.

Here is how the volatility chart should look for a covered call play:

Here is how a volatility chart looks in the real world:

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This example is almost too good. You want the 30-day historical volatility (stock price) to be in
the lower half of the chart. Remember, the mid-point of the chart is calculated by adding the
lowest value of the chart (30) to the highest value of the chart (80), which equals110, and
dividing by 2. The halfway point is then 55. As you can see, the 30-day historical volatility
(the stock volatility) is at the bottom of the chart (underpriced). You want the implied
volatility (IV) to be in the top half of the chart (overpriced). In this case it most certainly is. If the
stock is in an uptrend, not hitting against resistance and not about to declare earnings before
the April options expire, it would appear to be a great time to buy the stock and sell an option
against it.

Here is another example, again the result of a very successful search.

The midpoint of this chart is (25 + 65)/2 = 45. The HV (Stock) is about 32.5, which means
it is underpriced. The signal is to buy the stock. The IV (surrogate option) is well above 45,
which means it is overpriced. The signal is to sell the option.

Volatility should not be used as a single-source buy-sell indicator. Trend, earnings, support, and
resistance must also be considered. Normal indicators tell me if I am getting a good stock.
Volatility tells me if I’m getting it at a good price. Additionally, trading on the right side of vola-
tility dramatically increases my chances of a winning trade.

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