Forex Options VII – Market Timing
As we have seen in our previous videos, many elements play essential roles in the success ( or failure) of options trading. Another important factor in deciding which options strategy to choose is the market action. Thus, market timing plays a crucial role in the success of the options trader. Timing the market when directly investing in an asset, especially in intraday trading, is essential. That is true also for option strategies that rely on the movement of the underlying security.
When trading options, the usual market situations to analyze are
- The underlying asset is expected to move in a particular direction within an assumed period.
- The asset is likely to go in a determined direction but without a specified period.
- The security is expected to experience a large movement but without a known path.
- The security is likely to move in a range.
Under the preceding scenarios, an options trader can be profitable if:
- He is right about the scenario
- He uses the precise strategy for the market and current volatility.
Usually, the first factor (being right) makes you money, whereas the second one determines the amount won, and the maximum loss when wrong.
The underlying asset is expected to move in a particular direction within an assumed period
Market timing is essential when planning to buy puts or calls because if we buy a call and the market drops, we will lose money. When developing a short-term strategy, the best test for the entry rules is to measure the profit after a certain number of days. such as in
Profit = Price [x] – Price,
being x the number of days after entry and testing it for different values of x. The advantage of using a time window is that it allows the trader to focus on a strategy with determined expectations.
If the trader’s time frame is one month or more, he should care about volatility. If it is exceptionally high, he will pay more time premium, which will decline over time, but if he intends to sell it in five days, he will not need to be concerned about it, as decay will be minimal. The disadvantage of trading in a reduced time frame is that the asset must move within the period, or the strategy will lose money.
The asset is likely to go in a determined direction but without a specified period
Often, traders expect an asset to rise or fall but don’t have clues about when that will happen. Options can be used under this scenario, although, in this case, volatility should be monitored and considered. When there is no specified time frame, the trader must usually keep the option near to its expiration; thus, time decay or volatility decline will eat part or all the expected profits.
The security is expected to experience a large movement but without a known path
Profiting from this scenario is unique to options trading, as options allow the possibility to profit indistinctly from rises or falls in the price of the underlying asset. The most usual strategy is buying straddles, the combination of a call and a put. Since this strategy is relatively expensive, it is best for low volatility periods ( the market is in a range) where you expect a sudden movement. If right, the combination of implied volatility increment, and price movement will pay the initial cost. Indicators that may help with this strategy are ADX, RSI, historical volatility, ATR, and Percent R.
The security is likely to move in a range
This is another scenario only profitable using options. In the case of the asset moving in ranges, which happens two-thirds of the time, the options trader may profit in several ways. Indicators such as Percent R or support/resistance assessment can determine overbought and oversold levels and use these timing techniques to options. For example, sell out of the money calls in overbought markets to profit from the premium at expiration. Other option strategies that profit from ranges are buying calendar spreads, vertical spread selling, selling puts at support levels, and advanced combinations, such as Butterfly spreads.
THE OPTION TRADER’S GUIDE TO PROBABILITY, VOLATILITY, AND TIMING , by Jay Kaeppel