Technical Analysis on Volatility (My Conceptual Framework)

This post is a continuation of research from my initial blog post "Introducing my Technical Analysis Framework For Options Trading".  My belief and thesis is that technical analysis can and should be applied to analyzing volatility, which could perhaps even help to predict future price behavior.


Technical Analysis on Volatility (My Conceptual Framework)

Does technical analysis work?  Take any of the countless number of technical indicators and confirm their effectiveness by simulating the trading rules over sufficient period of time and one would come to a disappointing conclusion.  Justifiably so, most people would say technical analysis does not work.

I believe the reason why technical analysis, in general, has not been so effective is because technical analysis has focused on analyzing Price and/or Volume over Time.  Yet, these arise from the outcomes of the continuous interaction and intersection of buyers and sellers in a market.  By definition, the moment price occurs, it is already in the past.  In other words, technical analysis and indicators on a chart show us what has happened, not what will or is likely to happen.  In hindsight, it is always easy to know the outcomes of a decision and go back and choose what would have been the “right” decision.

Perhaps, it is time to reapply technical analysis to what it is really good for.  Technical analysis, indicators and charts are really good tools for perception.  Markets, price, volume, time, trend, etc. are all metaphysical objects.  Ask the question, “What is a trend?” and you would get countless answers, which is the same as no one answer.  This is akin to asking the question “What is love?”.  In addressing the process of perception, I came up with my own philosophical concept to more objectively perceive any object, physical or metaphysical.[1]

The key to greater understanding and awareness is to perceive anything in multiple or higher dimensions.  Once again, technical analysis is a great tool for perception.  If we apply this tool to volatility (a different, perhaps higher dimension of price) I believe we can get a much better understanding of price and utilize this understanding for profit.

Profitability of buying or selling a stock is a function of volatility.  With zero volatility, zero profits.  Furthermore, when perceiving price through volatility, one does not have to try to predict the direction of price, but rather if there would be sufficient price movement in order to realize a profit.  In fact, in options/volatility trading, one could also potentially profit from little or no volatility.

I tested these conceptual assumptions with a volatility trading strategy on the SPDR S&P500 (SPY) ETF.  I utilized two volatility indicators and applied technical analysis tools on them for timing of when to buy an options straddle and when to sell an options iron butterfly with outside strikes 5% away from at-the-money strike.  Additional details include using nearest month options with expiration at least greater than 10-trading days away.  Commissions cost of 0.75 per contract and slippage of 0.05 for the entry & exit trades were included.  The contract size was set at 10 straddles and 10 iron butterflies.  Also, no delta hedging was involved.  Finally, the simulation was conducted from beginning of 2012 until August 2013 expiration, the first entry trade posted on 2/14/2012.  The simulation was conducted with thinkBack, a backtesting tool on the thinkorswim platform using end of day marks on options prices.

Strategy	Profits (Gross/Net) STDEV of Daily Net Profits Change Potential % Return
Buying next month straddle on expiration day (cyan)	$10,470 / $8,130 $642 (1) 56.9%
Selling next month iron butterfly w/outer strikes 5% away on expiration day (yellow)	-$18,055 / -$20,935  $463 (2) -100%
Selling iron butterfly w/outer strikes 5% away using volatility timing (red)	$5,790 / $2,910 $164 (3) 57.0%
Buying straddle, Selling iron butterfly using volatility timing (blue)	$9,420 / $4795 $510 (4) 57.1%

(1)   minimum account size required in hindsight would have been $14,285 to cover for $7,285 maximum loss and $7,000 to initiate a position.

(2)   Surprisingly over the time period, selling an iron butterfly at the start of each expiration month would have led to consistent losses.

(3)   A minimum of $5,100 would have been required in hindsight.

(4)   A minimum of $8,400 would have been required in hindsight.

The chart and the table shows simulated results and are for research and education purposes only.  More research would be required on longer time periods, out of sample data, and many more underlying instruments and options on those instruments in order to test the efficacy of technical analysis on volatility.  Yet, the strategy to buy and sell options based on volatility indicators seems to show promise.

The volatility indicator used for long straddle entry is my Realized Volatility indicator.  Details of the Realized Volatility indicator is discussed in my post “FairVolatility (VIX) Model & Indicator, part I”.  The volatility indicator used for short iron butterfly entry is the Standard Deviation indicator in Metastock software.  Logically, when Realized Volatility is seen increasing, one would want to buy the straddle in order to take advantage of  potential increase in implied volatility and expected price movement.  On the sell side, one would want to sell an iron butterfly if the directional movement of the underlying is expected to slow down or be range bound.  No distinction was made in this simulation as to the relative levels of implied volatility vs. realized volatility but could be parameters for further research.

More specifically, the rules were:

1)      Buy straddle when the criteria for Realized Volatility moving up was triggered. Simultaneously exit any open short iron butterfly position.

2)      Sell iron butterfly when the criteria for standard deviation indicator moving down was triggered.  Simultaneously exit any open long straddle position.

3)      Exit any open short iron butterfly position if criteria for standard deviation indicator moving up was triggered.  (Usually, the two indicators moved in same direction with Realized Volatility leading standard deviation.  There were few instances where Realized Volatility remained in a down move but standard deviation started to move up.  This happened in prolonged up move in SPY prices.  In these instances, the short iron butterfly position was exited w/o corresponding long straddle trigger.)

The technical analysis indicators used for timing on these volatility indicators for long and short entry will not be mentioned here, because I am certain through continued research that more effective timing indicators can be found.

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[1] http://thirdeyeinsight.wordpress.com/2013/02/03/what-is-love-the-path-towards-enlightenment/