In an earlier blog post, I discussed the ability to figure out the expected move based on volatility. Though there are extensive data science books written solely to extol the value of forecasting stock prices using statistical models and machine learnings, I prefer to rely upon trusty volatility as basis for my predictions. Why? 1. It’s to-the-point and saves me the hassle of looking at the output of probability based forecasts from different statistical models. 2. There’s actual market participation. Volatility is driven by fear or greed in the market and can provide me with a more realistic and tangible understanding of expected movement.
While predicting the price of a stock in the future might be a good research exercise, it is also a great tool for finding trading opportunities. If a stock or underlying has moved quickly to an extreme, I can take the contrarian view and fade the move.
Let’s work with an example. The figure below shows different underlyings and their associated volatility tickers created by CBOE.
On Thursday evening Soybean (SOYB) had closed at $17.56. It’s volatility SIV had closed at 20.99. Based on this, the one day, one standard deviation move expected was $0.19. Here are the calculations:
But around noon the next day SOYB was trading at $17.98 which was more than twice the expected $0.19; SOYB had moved more than two standard deviations from the prior day’s expected move. The degree of confidence for a 2 SD move is about 95%, that is to say there was only 5% chance that market was expecting this kind of move! Given such an extreme move, as a contrarian, I’d fade the move to short soybeans. Since SOYB is thinly traded with wide bid-ask spreads, I’d short the futures /ZS or maybe even short a put along with it to add a positive theta component.
Here’s another exercise expected move with SPX and its volatility VIX. For now, let’s ignore the news surrounding the market: bulls vs. bears, political environment fueling the market, or how high it is. Let’s instead try to quantify it.
I’m choosing the date of 2/11/16 which printed the lowest point in recent (short) memory – about 500+ days go. If we took the closing prices of 2/11/16, we can figure the expected move till today and see that SPX has been hovering pretty close to this number:
Here are all the standard deviations using 507 days since 2/11/16 when SPX was at 1829.08 and VIX was at 28.14 as:
If we see the large jump in the price of the stock beyond the given SDs, we can take the contrarian view to fade the move.
In this post, we explored another way to look for trading opportunities- this time using the expected move!
Stay tuned for more posts from NishaTrades!
As discussed in the "Expected Move" post, the expected movement of a stock can be calculated with the following formula, where S subscript 0 is the stock's current price, IV is implied volatility, and the final term is the square root of days to expiration divided by 365:
Though an intimidating formula at first glance, it provides traders with the approximate range in which a stock's price may travel in a given amount of time or days to expiration (DTE). Note: The image above should say plus or minus preceding the square root sign.
To visualize, let's look at an example. Assume a SPY stock's price on low for the year on Feb 11th 2016 as $182.86, with an implied volatility of 28.14%. To calculate the expected move in 30 days, we substitute "DTE" with actual number of dates and solve for EM.
The plus or minus range for each expiration will approximately equate to the EM calculations using the mid-price fills of EM spreads and the MMM value.
. The expected movement of a stock's price can be computed/deduced in several different ways. Some of my 'go to' techniques are:
(a) Use the price of the front month (week) straddle. Here we check the price of selling the ATM call and ATM put. The expected movement of a stock's price when using a straddle strategy is the sum of the mid-price fills between the bid-ask spread for selling ATM calls and put.
Example: Say the ATM call has a bid/ask spread of $1.10 and $1.20, we can assume the mid-price fill of $1.15 similarly, say the ATM put has a bid/ask spread of $1.40 and $1.50, we can assume the mid-price fill of $1.45 So the straddle would cost $1.15 + $1.45 = $2.60 This would imply an expected move of $2.60 from the current price. Most seasoned traders will consider 80% of this straddle price ($2.60 x 80% = $2.08) as the expected move, I'd like to be a bit more conservative in my trading.
(b) Use of MMM (on ThinkOrSwim platform) MMM is the Market Maker Move displayed on the 'Trade' tab of the ThinkOrSwim platform. It's the expected move as computed by the platform.
(c) Use of expected move formula: Expected Move = Stock price x IV x Square Root (Days to Expiration/365.25)
(d) Use of option greeks: We look at delta to deduce the 1 Standard Deviation move in the front month. We'll look at the strike price of the options with 16 delta which equates to 68.2% probability of falling in the money or 30 delta which equates to 50% probability of falling in the money. By using these strike prices, we are deducing the probability of success.
Eighteen-year old trader, future connoisseur of options.
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