Options, at times, confer advantages over underlying positions. Specifically, options offer:

- Staying power-buying an option limits risk to the premium paid. Options are thus useful when trying to pick tops and bottoms. These are risky propositions, but judicious use of options can help mitigate some of the inherent risks in such endeavors.
- The ability to benefit in sideways markets-by using options, one can profit if the underlying contract trades in a lateral range (by selling straddles or combinations).
- Strategy flexibility-one can tailor risk/reward parameters to one’s price, volatility, and timing projections.
- Occasionally superior leverage-for instance, if the market swiftly rallies, under certain circumstances, an out-of-the money call may provide a greater percentage return than would an outright position.

## OPTIONS BASICS

Before discussing how candlesticks can be used with options, we’ll want to spend some time on option basics. The five factors needed to figure the theoretical value of a futures options price are the exercise price, the time to expiration, the price of the underlying instrument, volatility, and, to a minor extent, short-term interest rates. Three of these variables are known (time until expiration, exercise price, and short-term interest rates). The two components that are not known (the forecasted price of the underlying instrument and its volatility) have to be estimated in order to forecast an option price. One should not underrate the importance that volatility plays in option pricing. In fact, at times, a change in volatility can have a stronger impact on option premiums than a change in price of the underlying contract.

Consider as an illustration an at-the-money $390 gold call with 60 days until expiration. If this option has a volatility level of 20%, its theoretical price would be $1,300. At a 15% volatility, this same option would be theoretically priced at $1,000. Thus, volatility must always be considered since it can so forcefully affect the option premium.

Volatility levels provide the expected range of prices over the next year (volatilities are on an annual basis). Without getting into the mathematics, a volatility of 20% on, say, gold suggests that there is a 68% probability that a year from now gold’s price will remain within plus or minus 20% of its current price. And there would be a 95% chance that a year hence golds’s price will remain within plus or minus two times the volatility (that is, two times 20% or 40%) of its price now. For example, if gold is at $400 and volatility is at 20%, there is a 68% chance that its price after one year will be between $320 and $480 (plus or minus 20% of $400) and a 95% probability that it will be between $240 and $560 (plus or minus 40% of $400). Keep in mind that these levels are based on probabilities and that at times these levels are exceeded.

The greater the volatility the more expensive the option. This is due to at least three factors. First, from the speculators’ point of view, the greater the volatility, the greater the chance for prices to move into the money (or further into the money). Second, from a hedger’s perspective, higher price volatility equals more price risk. Thus, there is more reason to buy options as a hedging vehicle. And, third, option sellers also require more compensation for higher perceived risk. All these factors will buoy option premiums.

There are two kinds of volatility: historic and implied. Historic volatility is based on past volatility levels of the underlying contract. It is usually calculated by using daily price changes over a specified number of business days on an annualized basis. In the futures markets, 20’or 30 days are the most commonly used calculations. Just because a futures contract has a 20-day historic volatility of 15% does not mean it will remain at that level during the life of the option. Thus, to trade options it is necessary to forecast volatility. One way to do this is by having the market do it for you. And that is what implied volatility does. It is the market’s estimate of what volatility of the underlying futures contract will be over the options’s life. This differs from historic volatility in that historic volatility is derived from prior price changes of the underlying contract.

Implied volatility is the volatility level that the market is implying (hence its name). Deriving this number involves the use of a computer but the theory behind it is straightforward. To obtain the option’s implied volatility, the five inputs needed are the current price of the futures contract, the option’s strike price, the short-term interest rate, the option expiration date, and the current option price. If we put these variables into the computer, using an options pricing formula, the computer will spit back the implied volatility.

Thus, we have two volatilities-historic, which is based on actual price changes in the futures, and implied, which is the market’s best guess of what volatility will be from now until the option expires. Some option traders focus on historic volatility, others on implied volatility, and still others compare historic to implied.

## OPTIONS WITH CANDLESTICKS

If a strong trending market has pushed volatility levels to unusually high levels, the emergence of a candlestick reversal indicator may provide an attractive time to sell volatility or to offset a long volatility trade. In this regard, the most effective candlestick formations may be those which imply that the market will move into a state of truce between the bulls and bears. These include the harami, counterattack lines, and other patterns.

Selling volatility could be done in the expectation that with the candlestick’s signal, the market’s prior price trend will change. If it changes to a lateral band, all other factors being equal (that is, no seasonal volatility factors, no expected economic reports, and so on), volatility could decline. Even if prices reverse, if volatility levels were uncommonly high to begin with, volatility may not increase. This is because the push in volatility may have occurred during the original strong trend.

Candlestick reversal signals may also be useful in helping the technician decide when to buy volatility (or to offset a short volatility trade such as a short strangle or straddle). Specifically, if the market is trading in a lateral band and a candlestick reversal indicator appears, the market could be forecasting that a new trend could emerge. If volatility levels are relatively low at the time of this candlestick reversal, the technician may not only see a new price trend, but also a concomitant rise in volatility. This would be especially likely if there is a confluence of technical indicators (candlesticks and/or Western techniques) that all give a reversal signal near the same price area.

Candlesticks, as tools to predict shifts in volatility, should be viewed in the context that these shifts will most likely be shorter term. That is, if one buys volatility keyed off of candlesticks and volatility does rise, it does not always mean that volatility will remain high until that option expires.

Exhibit 18.1 shows that there were two top reversal warnings in mid-May. The first was a doji after a long white real body. Next, were the three black crows. Historic volatility expanded during the selloff which started from these top reversal formations. The end of this selloff came with early June’s harami cross. Then the price trend changed from lower to lateral. Volatility contracted due to this lateral price environment.

Thus, for those who were riding volatility on the way up, the harami cross could have been viewed as a signal to expect an end to the prior steep trend and, consequently, the possibility of a decline in volatility.

Based on experience, and for various other reasons, candlestick signals seem to work better with historic volatility than with implied volatility. Nonetheless, as shown in Exhibit 18.2, candlesticks, at times, can be useful instruments to assist in forecasting short-term moves in implied volatility. A sharp rally developed in January. During this phase, implied volatility ascended along an uptrend. For much of February, sugar was bounded in a $.I4 to $.I5 range. In this period of relatively quiet trading, volatility shrank.

On February 26, a hammer appeared (area A in Exhibit 18.2(b)). In addition, this hammer session’s lower shadow broke under the support area from late January. This new low did not hold. This demonstrated that the bears tried to take control of the market, but failed. Three trading day’s later, on March 2, (area B in Exhibit 18.2(b)) the white candlestick’s

lower shadow successfully maintained the lows of mid-January. In addition, the March 2 low joined with the hammer to complete a tweezers bottom. The combination of all these bottom reversal indicators sent a powerful signal that a solid base had been built. A significant rally was thus possible. As shown in Exhibit 18.2(b), volatility at areas A and B were at relatively low levels. With a possible strong price rally (based on the confluence of bottom reversal signals discussed above) and low volatility, one could expect any price rallies to be mimicked with expanding volatility. That is what unfolded.

Another use for options and candlesticks is for the risky proposition of bottom and top picking. Just about any book on trading strategies warns against this. But let’s face it, we all occasionally attempt it. This is an example’ of how the limited risk feature of options may allow one to place a trade too risky for an outright future. Exhibit 18.3 is an example

of a trade I recommended. I would not have made such a recommendation without the limited risk feature of options.

Cocoa was in a major bull market that started in November 1989 at $900. This exhibit shows the last three waves of an Elliott Wave count. The top of wave 3 was accompanied by the shooting star and the bottom of wave 4 by the bullish piercing line. Based on a Fibonacci ratio, there is a wave 5 target near $1,520. Thus, near $1,520 one should start looking for candlestick confirmation of a top. And in late May, a bearish engulfing pattern emerged after the market touched a high of $1,541. This was close to the Elliott Wave count of $1,520 which signaled a possible top.

I could not resist such a powerful combination of an Elliott fifth wave and a bearish engulfing pattern! Options to the rescue! I recommended a buy of the $1,400 puts (because the major trend was still up, I would have been more comfortable liquidating longs, but unfortunately I was not long during this rally). If I was wrong about a top and cocoa gapped higher (as it did in mid-May), increased volatility could help mitigate adverse price action. As it turned out, this bearish engulfing pattern and Elliott fifth wave became an important peak.

Source/Credit : Steve Nison