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Tech Talk On The Markets

Author: Bob Lang (info)
Website: http://trade-mentor.com
Posted: January 30th, 2007 at 9:32 am EST
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It’s been quite a rollercoaster year so far. Last week was no exception either, with a plunging VIX and then a sharp rise. Earnings season is clearly in the driver’s seat for the next few weeks. We’ve seen a mixed bag of results with some companies being rewarded for good results while others have been blasted. It’s pretty much interpretation and guidance that sways investor opinion.

During the week, gold rose smartly up to the $650 level before backing off, while oil also managed to gain off its recent slump. The Dow Industrials did manage to make a new all-time high, while the SPX hit a new six year high. It should be noted that the ‘500 is less than 9% away from an all-time high, last seen in 2000.

This week brings more earnings, including Google…and another Fed meeting. In relation to the Fed, bonds were slammed last week, pushing yields upward of 4.86%…a level not seen since August of 2006. We’ll see if this aids the Committee in their decision-making process.

HOW VOLATILITY PLAYS INTO MY CHOICES

I’m often asked how and why I choose particular plays. In the two option portfolios I manage, GrandSlam Options and Extreme Options…I often use the current volatility environment to aid me in making the highest probability play. Let’s discuss volatility for a moment.

A high level of volatility means the market is expecting drastic fluctuations in price, whereas a lower volatility environment is just the opposite. We’ve been living in a lower volatility for what seems like years, and it’s true…the highest VIX level since 2003 has been just under 25.

So, it’s been a ‘relatively’ low volatile environment. How does this work in play selection? When making a directional play or spread trade in a low volatility environment, the best odds come in playing the direction with a longer time horizon. Options are short-term in nature, so I try to give myself plenty of room to make it work, because low volatility by definition is low pricing risk. But I WANT a sharp price move, If I’m right with all of my technicals pointing the way, there should be nothing wrong in taking more time.

Further, taking an option closer to the money or even in the money is a better bet than out of the money. Why is this? Again, in a low volatility environment, it takes a great deal of price pressure to get to the objective, which is the strike…when the option really comes alive with value. This is asking too much in a choppy or low volatility environment…you won’t get paid correctly for the move. You may ask, what’s wrong with going far out with an out of the money? Well, you end up paying up for the time in some heavy time premium…and if the market chops around, their goes your premium. We could basically flip these strategies over in a ‘relatively’ higher volatility market…where you’re not paying dearly for time premium.

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