Friday, July 5, 2013

An Option Trader’s View of New Highs in the S&P 500 Index

by J.W. Jones

Every investor and novice trader is looking for a newsletter that exemplifies the holy grail of investment acumen. It would seem that so many newsletters promote their latest or greatest trade idea. If the trade idea works, readers get quickly reminded of the analyst’s success. However, failed predictions about future price action in stocks typically are ignored by the analyst in subsequent articles.

I do not make wild predictions about the future prices of anything; much less make suggestions that are not based first on option chain derived probabilities. In fact, I spend most of my time studying probabilities that are driven by implied volatility calculations in the equity options marketplace. From an option standpoint, I would characterize myself as a volatility trader. I focus on equities which have implied volatility levels that are significantly higher than their historical norm.

Obviously I do take trades that are directional in nature, but I am typically contrarian in my view of the marketplace. I use very little technical analysis because most studies are not profitable consistently because of their inability to remedy the passage of time as a function. This more simply can be described as a false signal that is generated due to consolidating or choppy price action. When you hear the term price action moderated as a function of time rather than price, many times indicators and oscillators have thrown off failed signals that lead to losses.

Instead of having my screens full of indicators and analytical tools, I spend most of my days looking at option chains and price charts. My view of the marketplace is simple. Sell when prices are near recent highs and buy when prices are near recent lows.

As an example, recently I heard an analyst on television say that the S&P 500 would get to 1,700 by the end of the year. Instead of listening any further, I pulled up an S&P 500 Cash Index (SPX) option chain and looked at the December Quarterly contracts for more clarification.


As can be seen above, based on current implied volatility level calculations the analyst has a probability of being correct based on the July 2, 2013 close of about 28%. As shown below, in order for price to get to the 1,700 price level by the end of 2013, we would need to take out the all-time highs set back on May 22, 2013.


I have identified the key price levels on the chart above which ultimately have an impact on the short to intermediate term price action in the S&P 500 Cash Index. However, what is more important to understand is that the probabilities are not overwhelmingly favorable that a move to 1,700 will take place that holds through the end of the year.

Based on current market conditions, the odds of us taking out the all-time highs before 12/31/2013 are a little better than 1 out of 4. In reality, these numbers indicate that any perma-bulls out there should be cautious.

However, the short-term bulls out there or those analysts that are pontificating about new all-time highs being set in the near future need to consider the July monthly option expiration probability data which is derived yet again from implied volatility calculations.

As of the close of trade on July 2, 2013 the probability that the S&P 500 Cash Index (SPX) will close above 1,700 on Friday, July 19,2013 is less than 1.76%. The July monthly SPX option chain shown below highlights this important information.


I want to be clear that these probabilities change every day based on price movement and changes in the underlying asset’s implied volatility levels. However, what does not change are the standard deviation calculations that govern this data.

Based on the closing data for the S&P 500 Cash Index (SPX) on July 2, 2013 a one standard deviation move to the upside (68% Probability Price Stays Below This Strike) would be the 1,635 SPX July Calls.

Based on the closing data for the S&P 500 Cash Index (SPX) on July 2, 2013 a two standard deviation move to the upside (95% Probability Price Stays Below This Strike) would be the 1,685 SPX July Calls.

Based on the closing data for the S&P 500 Cash Index (SPX) on July 2, 2013 a three standard deviation move to the upside (99% Probability Price Stays Below This Strike) would be the 1,715 SPX July Calls.

While this data does not reveal precise expectations for future price action in the S&P 500 Cash Index (SPX), it does shed context on the wild predictions some of these television and newsletter analysts provide. In financial markets anything is possible, but I will continue to trade using statistical analysis that has been proven to be effective over long periods of time when large quantities of trades are taken.

I prefer analysis that is backed by statistical studies versus a quantity of indicators that all have their own set of limitations. While the probabilities are not always going to be favorable, over long periods of time the numbers will solidify the trading results.

While there is much more to my strategy than just this basic explanation, I was hoping that readers could come to understand that there is a mathematical way to use statistical analysis to enhance trading results.

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