- 2000: Volume 9, No. 5 Fine Tuning Option Entries and Exits With Trading Bands

The key to successful option trading often depends on not only selecting the correct option strategy but also determining an objective entry and exit point. By employing the use of trading bands, these problems can usually be eliminated. The two trading bands, which I feel are the most appropriate, are the STARC and Bollinger Bands.

STARC Bands

The STARC bands (Stoller Average Range Channels) developed by Manning Stoller in the late 1980s are based on the true range. This is calculated by taking the largest absolute value of the following three calculations; H-L, H-C or L-C. Then a 15-day average is taken of the true range, which is referred to as the ATR. To determine the STARC+ or the upper STARC band you add 2xATR to a six-period simple moving average (6SMA) and for the STARC- or lower STARC band, you would subtract 2xATR from the (6SMA). Approximately 90 percent of the time prices will stay within the bands. If 3xATR is used instead of 2xATR then almost 100 percent of the price action is contained between the upper and lower bands. Unlike other trading bands based on percentages around a moving average, the same formula and same parameters are used for any market and any time frame. Therefore, they do not have to be adjusted or optimized for a particular market.

How To Use STARC Bands

There are a variety of uses for STARC bands, but the most basic is to determine high and low risk buying or selling opportunities. If prices are near or at the upper bands (STARC+) it is a high-risk time to buy (establish a long position) and when prices are at or near the lower bands (STARC-) it is a high-risk time to sell (establish a short position). This does not mean that the market will automatically reverse direction once the bands are reached, but it increases the odds that the market will either bounce in the opposite direction or at least move sideways for several periods. This can be very important when a market is moving sharply either up or down and has been doing so for three or four bars as the impulse to chase the market becomes unbearable.

Often traders cannot resist the urge to buy or sell at these extremes only to have the position quickly go against them and stop them out. Invariably, the market will then resume its original direction, leaving the trader without a position and very frustrated. By noting the relationship of prices to the STARC bands, one can gauge the risk on either the short or long side. An option trader's strategy can then be adjusted in relation to the STARC bands. If prices are at the STARC+ band, call buying would be a high risk, while a bearish strategy such as buying puts or establishing a bear spread, would be a lower risk. For example, the week of 10/3/97, point 1, Crude Oil, basis the nearby futures, closed above its upper weekly STARC band, which is a fairly uncommon event. By definition this was a high-risk area for long positions, but a low risk opportunity for short positions. Therefore, at point 1, put buying, call selling or bear spreads had the best risk/reward profile in terms of the STARC bands.

Figure 1:

The STARC bands can also be used to help identify profit-taking zones. After the weekly STARC+ band was exceeded at point 1, over five months passed before the lower daily STARC band was reached, point 2. As discussed previously, both points 2 and 3, represented favorable risk situations for establishing long positions, such as put selling, bull spreads or call buying. Over the years, the most common complaint or money management mistake that option trader's express is that they stay with a position too long. This is especially true with naked put or call buyers. They will put on a position which immediately goes in their favor and may double in a short period of time. Even though this may have been their original goal, often greed sets in and instead of taking some or all of their profits, their judgment is clouded with visions of 300 to 500 percent gains. Ultimately, they hang on too long and are lucky to get out with any profit at all. The weekly STARC bands can be used as a guide to help avoid this reoccurring trap. As points 4, 5, 6 and 7 illustrate, taking profits once prices reach the weekly STARC bands historically has been advantageous. Although some of the retracements were not that large, some were—Crude Oil dropped over per barrel from point 6 to point 7.

Bollinger Bands

Bollinger Bands were developed by John Bollinger and are calculated by taking a 20-period moving average and then adding two standard deviations to the moving average to get the upper band and subtracting from the moving average to get the lower band. These are the default settings but John Bollinger recommends different settings for different markets and if the length of the moving average is increased say to 50 from 20, then 2.5 standard deviations are used. This is a drawback when compared to STARC bands where the same parameters are used for stocks, futures, cash etc.

Use of Bollinger Bands

Like STARC bands, Bollinger Bands are used in many different ways as some traders apply them to identify price extremes. Others use them as a sort of trading system as if prices move above the 20-day moving average then the upper Bollinger band should be reached. Conversely, if the moving average was violated, then the target would be the lower band. Closes outside of the bands are viewed as continuation signals that are similar to those generated by volatility breakout systems. John recommends using them primarily in conjunction with other technical indicators and a full discussion can be found on his Web site at www.bollingerbands.com.

Since the bands narrow when volatility is low and expand when it is high, I prefer to use them as a measure of market volatility that has a particular attraction for option traders. On the chart found in Figure 2 of September Eurodollars, the area indicated by point 1 shows a period of high volatility as prices exceeded the upper Bollinger band for several consecutive days. Times of high volatility usually correlate well with high option premiums. As a buyer of options, you should look to get out of your positions once the bands start to expand. If on the other hand, you are a seller of options then the high volatility i.e. high premium situations should provide the best opportunities since the premiums will decline, especially if volatility contracts.

Figure 2:

Bollinger Bands are most useful in helping identify periods of low volatility which often occurs at significant turning points. Specifically, they are useful not only at major tops or bottoms but also in anticipating when trading ranges are soon to be resolved. In Figure 2, the Eurodollar futures consolidated from the latter part of January 1998 until early August 1998. Volatility was high at point 1, then contracted some at point 2, and was quite low at point 3, as the Bollinger Bands narrowed. This implied low option premiums and since the last major move was up, the long side of the market was favored. Eurodollars broke out of their trading range by mid August 1998 and within a few weeks the Bollinger Bands had widened dramatically. Prices first exceeded the upper bands in late August and then made two more thrusts above the bands as indicated by the arrows at point 4. Three such volatility extremes are often observed before the cycle is likely to reverse. Therefore, in early October, with the Eurodollars trading near 95.40, the Bollinger Bands suggested that a neutral or bearish strategy was advised with high premiums favoring the selling of options.

Integrating Trading Bands Into a Trading Strategy

Even those with a well-defined option trading strategy can benefit from the use of STARC or Bollinger Bands. Over the past four months the S&P futures have been trading in a 200+ point range which has afforded little opportunity for those looking for a trend to trade, but has been much more accommodating for neutral strategies. By noting the readings from the STARC bands, those who were establishing bullish strategies could have done better establishing them at points 2, 3 and 5, then at points 1 and 4, where bearish strategies would have been favored.

Figure 3:

In conclusion, while neither STARC or Bollinger bands were designed for option traders, they can provide useful and timely input to option traders. They can be helpful not only in determining option strategies but also in selecting exit and entry points.

Tom Aspray, is the chief analyst and director of market education for INO.com. He has been a regular speaker at TAG conferences and this year will be giving a pre-conference workshop with John Murphy. Tom's daily market commentary is available at: http://quotes.ino.com/analysis/commentary.

John Bollinger will also be a speaker at TAG. For more information about Bollinger Bands and to read several articles on how he uses the Bollinger Bands, visit his site at: www.bollingerbands.com.

Both will be featured speakers at TAG 22 taking place October 12-15 in Dallas, Texas. For registration information, call 1-800-538-7424 or log on to www.ino.com/tag.