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This week I would like to talk about a terrific tool for option traders. Before launching into it, however, let me first preface all of this with the following: when you buy a stock, either it goes up in price and you make money, or it goes down in price and you lose money. It’s pretty straightforward. In the world of option trading the choices are much different. With options you can create a position to take advantage of just about any scenario you expect to see unfold. If you expect a sharp advance or decline, you can buy calls or puts and magnify your gains. If you expect a modest advance or decline you can buy a bull call spread or a bear put spread. If you expect a stock to break out of a consolidation in a big way, but are not sure in which direction, you can buy a straddle. Likewise, probably the most unique thing about option trading is that you can make money when a stock goes nowhere. By writing options – or “selling premium” – you can enter a position with a fairly high probability of making money even if the underlying stock simply stays or at least ends up within a particular price range.

When trading individual stocks, the most important factor is timing since you have to have the stock move in the right direction or you lose money. Timing is very important with options also. However, there is another key factor involved and that is volatility. “Statistical” volatility measures the movement of the underlying security – i.e., the magnitude of the fluctuations in the price of the stock. “Implied” volatility measures the relative amount of time premium built into the price of the options for a given security. In other words, if the implied volatility for the options on a given stock is on the high end of its historical range, it means there is a lot of more time premium built into the price of the options than if implied volatility were at the low end of its own historical range. In essence, statistical volatility tells you how much the stock fluctuates in price, and implied volatility tells you whether the options on that stock are “expensive,” “cheap,” or somewhere in between. Armed with this information, an astute option trader can make intelligent decisions regarding the strategy to use and the actual trade to make in any given situation.

So the tool I want to talk about this week is in Optionetics Platinum software and is called "Gyration Stock Finder." Now like a lot of users when I first encountered this routine I think my first reaction was, “huh?”  Figure 1 displays the default input screen for this routine.

Chart 1 – Optionetics Platinum Gyration Stock Finder Routine

As you can see in Chart 1, trying to make heads or tails of this input screen might be a bit intimating to the uninitiated. So to take a little bit of the mystery out of it, lets look at one simple example. As you can see in the lower right hand corner of Chart 1, we have selected settings to identify stocks that are trading inside a “closing channel." What does that mean? In a nutshell, that the stock is trading in an ever narrowing range. Let’s look at the output, which appears in Chart 2. As you can see the “top ranked” stock is Herbalife (HLF). Why is it “top ranked." Take a look at Chart 3.

Chart 2 – Gyration Stock Finder “Inside Closing Channel” Output

In Chart 3 you can see that HLF has been trading in an ever narrowing range and has crossed the center line of this range seven times to the upside and seven times to the downside. Very often, this is the kind of consolidation and “coiling” that takes place prior to a big move.

Chart 3 – Herbalife trading in a “closing range”

The obvious question here, “if there is going to be a big move, in which direction will it be”? The bad news is that there is no real clue offered by what we have seen so far. The good news is that, as I mentioned earlier, options afford opportunities not available to stock traders. In this situation an option trader could have bought the May 40 straddle – i.e., buy the May 40 call and the May 40 put. This trade and the attendant risk curves appear in Charts 4 and 5.

Chart 4 – Long the HLF May 40 straddle

Chart 5 – HLF May 50 straddle risk curves

As you can see in Chart 4, it would cost $780 to enter this trade. By entering this position, a trader has unlimited profit potential in either direction. The risk in this trade is that the stock will remain in a range and time decay will begin to eat away at the price of both options. For our purposes, we will target a profit of 25%, or roughly $200, as a good time to “take the money and run."

As you can see in Chart 6, the stock broke sharply to the upside. By 3/25, HLF had risen from 39.46 to 48.57.

Chart 6 – HLF runs to the upside

As you can see in Chart 7, at this point the May 40 straddle was showing a profit of $235. Thus a trader could have exited here with a profit of 30% in a little over a month.

Chart 7 – HLF May 40 straddle up 30%

Summary

Certainly not every trade will work out as well or as quickly as the HLF example above. Nor is the top rated “Inside Closing Channel” stock always going to be on the verge of an imminent and large breakout. However, the point in all of this is not to highlight the specific steps of some “world beater” strategy. The purpose here is simply to highlight the potential usefulness of a specific tool. There are many uses for the Gyration Stock Finder. In this piece I have highlighted one simple example, that being the ability to identify a stock in the midst of a serious consolidation. We also looked at an example of a strategy – a long straddle – that might be considered in this situation.

Many other possibilities exist.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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