Posted on October 12th, 2010 No Comments
A bought strangle is best purchased when volatility is low and expected to increase. There are a number of indicators to look at when analysing volatility. The primary indicators used are the implied volatility (IV) and (HV).
Implied volatility is the volatility implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model, yields a theoretical value for the option equal to the current market price of that option. Implied volatility, a forward-looking measure, differs from historical volatility because the latter is calculated from known past prices of a security. So when looking at the IV and HV we analyse to see if they are in an uptrend or look like they are going to increase. The main risk is buying a strangle when the IV and HV are in a downtrend.
Another measure of volatility is analysed through the Bollinger Band indicator. Options traders, most notably implied volatility traders, often sell options when Bollinger Bands are historically far apart or buy options when the Bollinger Bands are historically close together, in both instances, expecting volatility to revert back towards the average historical volatility level for the stock.-technical analysis. When the bands lie close together a period of low volatility in stock price is indicated. When they are far apart a period of high volatility in price is indicated. So when looking to enter a bought strangle it is ideal for the Bollinger Bands to be close together.
The final volatility indicator used is the Average True Range (ATR). The ATR indicator measures a security’s volatility. As such, the indicator does not provide an indication of price direction or duration, simply the degree of price movement or volatility. A rule I use when entering a strangle is to make sure the strangle does not cost more than 2-3 times the ATR. For instance if the ATR is 30 cents make sure the strangle does not cost more than 90 cents. What this means is that if the share price has 3 days in a row in the same direction the strangle should be at a breakeven level. The other indication is if the ATR is increasing and that means volatility is also increasing which is ideal for strangles.
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