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Know Your Limits

Accendo Markets
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The CBOE’s VIX Volatility has always seemed a bit odd to me. The best analogy that I can draw is that of the famous ‘uncertainty principle’ of quantum physics. In particular, how does one trade the index measure of volatility without affecting its own market volatility?

Rather philosophical, isn’t it? But the main point that follows is more practical for traders. If your style is to lock in profits using complicated options strategies then be aware that Bollinger Bands are an extraordinarily useful tool to establish a ‘baseline’ for the strike limits of your spread. I’ll use the VIX as an example.

Take a look at the chart below; a six month chart of the VIX. It’s mostly bounded by Bollinger Bands, with the usual parameters: a standard deviation of 2 and a period of 20 (days). In spite of the recent ‘rate hike anxiety’, VIX volatility, with few exceptions, has remained well within textbook measures of deviation. Fear, it seems, has its limits.

The VIX closed at a nice even 16.00 on Friday afternoon. All examples below are using prices at Friday’s close. Let’s take a look at the S&P over that same interval of time and the same Bollinger Band parameters. The sub-chart is volume. Observe that the volatility spikes and S&P dips outside of an S&P standard deviation, mirrors its VIX alter ego.

Bollinger Bands can help the trader visualize complicated spreads. A Butterfly Spread will serve as an example. Just as a refresher, a basic (long) Butterfly Spread involves purchasing a call, at a specific strike, shorting two out of the money calls at a higher strike and lastly, lastly buying one more deep out of the money calls.

Recently, the S&P seems to be adjusting to reflect, perhaps half a chance, that the Fed will raise its benchmark rate this June. But the uncertainty of the Fed action must limit the S&P to range between a full out correction and recent record highs. (Perhaps the Fed’s intent?) This is where the Bollinger Bands may be used to visualize the limits of the spread. First analyse a simulated trade: long one April 16 at the money call @$2.70, next short as close to the upper Bollinger band as practicable; two April 17 calls @2.25 each. Lastly, purchase one call at the next strike up above the upper Bollinger Band, in this case the April 18 @1.85.

Now use your broker’s Risk Profile and Probability Analysis. The cost of the position works out rather neatly: a debit of $4.55 for the long portions and a credit of $4.30 for the short positions, resulting in a limited loss of $0.25, for the entire position. The maximum potential is $0.43 per position (VIX at 17) . In this example a risk profile will show that the position has an 87% chance of being profitable between $0.25 to $0.43 per position. Again, this is a simple example. The key point is that the Bollinger Bands serve as a visual indicator for setting up the spread with the minimal risk. It demonstrates almost exactly the statistical range for which underlying is expected to trade in.

There are two ways to go from here. The first is obvious. Use risk profile and probability analysis to tweak the strikes in the spread. The second is less obvious but very useful. Most trading platforms allow the user to customize the Bollinger parameters, and plot multiple Bollinger Bands. Hence the standard deviations, for both upper and lower bands may be varied, or the period customized which would be useful for creating calendar spreads.

The point of the matter is that Bollinger Bands are a useful tool for the spread trader to see, at a glance, a baseline from which to build a position and thus take the guesswork out of using risk profiles and probability analysis alone.

CFDs, spread betting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary. Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.

Mike Scrive

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