When it comes to buying options, most traders focus on the premium paid rather than the potential returns. While this is important information in terms of making a calculated trade, many options traders tend to lose sight of the probability of the market reaching and exceeding its position's strike (or more importantly, its breakeven point).
For options trading, simple is often better. Adhering to this principle when deciding whether or not an option position is a good trade, begin by calculating the average monthly range of the market. This number provides perspective on two important elements of an options trade: whether volatility is expanding or contracting and if the market has a chance of reaching and exceeding the break-even point of the position. Read on as we uncover how to calculate and use the average monthly range in your options trading strategy.
Adding it Up
It is commonly said that the majority of options expire worthless. If that is a true statement and you are trading a position that is long premium (i.e. buying a call or a put), you need the market to have a chance of reaching a price that will make your option position profitable. When considering an option position, it is important to consider if it is probable that the market will reach that point. Just because the premium paid is cheap or underpriced does not make the trade a good one, especially if the market has little or no probability of reaching that goal.
To calculate the average monthly range, you do not need any special software or a doctorate in mathematics. However, you will need access to reliable historical prices. For any stock, you can get historical open, high, low and closing prices for a given date range. This will give you all the key numbers that will be used in the calculation - the high and the low for each trading day.
The average monthly range is nothing more than an average price within which the market fluctuates in a given month between its high and its low. More conservative traders could tighten this up and use the monthly open/close rather than the high/low. To calculate this average for a given period of time, subtract the low from the high for each month to get that month's range. For the time frame, add up each month's range and divide by the number of months.
Using the QQQQ as an example, we will calculate the six-month average range. These are the historic highs, lows and the range from a six-month period in 2007, as an example:
Selecting a Time Period
So how long of a period should be considered? Generally, it pays to look at a time frame of twice the length of the option position you are considering, and then break this up into two separate blocks of time. For example, if the option you are considering has three months of time to expiration, look at the average monthly range of the last three months, the three months prior to that and the last six months.
Using the QQQQ (Nasdaq 100 Trust) as an example, we find that as of June 2007, the previous three months had an average range of $2.55, the three months prior had an average monthly range of $2.46 and the six months combined had an average range of $2.51. The volatility of price is expanding somewhat, and we need to be looking for options that will perform within those conditions, performing within the confines of $2.50 move in a month. (For related reading, see Trading The QQQQ With In-The-Money Put Spreads.)
This means that if you are looking at buying either a put or a call on the QQQQ for August expiration, you should look for something no more than $7.50 out of the money - preferably much closer. A general rule of thumb for exactly how much closer you need to get is based on targeting a possible double of your investment. In this case, a 3:1 or 4:1 risk/reward ratio is preferred.
If the QQQQ is trading at 46.50 in June and the August 48 calls are trading at 1.00, the top of the average monthly range takes us to 54. QQQQ would need to trade to 49.00 for us to break even on buying the 48 calls for 1.00. An upside to 54 gives us a 5:1 reward/risk ratio. On the downside, if the August 44 puts are trading at $0.50, this will make the break-even 43.50. The average monthly range gives us the potential to move to 39.00, giving us a risk/reward ratio that meets our criteria.
When to Avoid this Strategy
In certain markets and at certain times, by using the average monthly range to choose options strikes, we may find that the implied volatility has pushed the option premiums to unreasonable levels. This causes smaller traders to buy strikes that are too far out of the money, simply because they want to be in a given market and have limited capital. In these cases, the use of the average monthly range should be telling you to either avoid that market, or to use a strategy that can get you closer to the current market price, such as a debit spread (bull call spread or bear put spread). (To learn more, read Option Spread Strategies and Vertical Bull And Bear Credit Spreads.)
The advantage of using the debit spread is that it gives the investor a limited risk position and gets closer to the current market than buying an option outright. It may also have a lower break-even point when compared to buying a far-out-of-the-money option. In exchange for a favorable position, the investor gives up the potential for unlimited gains, as in the case of the outright option, and instead must settle for a limited, yet defined, maximum gain. In certain market conditions, this may be a favorable tradeoff and will keep the investor grounded in the reality of what the market is more likely to do. The advantage of unlimited gains is usually only effective if the market makes a historic move, and those moves are very rare. If you are trading for long-term capital appreciation, that type of speculation will not allow you to stay in the game for very long.
The Bottom Line
While this concept can be applied to any market and any time frame, it is not intended to be used by itself. You still must have some type of directional analysis on the market, be it fundamental or technical. What this concept of the average monthly range is intended to do is to keep you from buying "cheap," far-out-of-the-money options that have very limited possibility of producing a return.