Buy Options when the ROC Indicator on the Underlying is oversold or overbought.
This strategy to buy options attempts to identify periods when up or down trend may be ending and a reversal is likely. It looks for ROC to reach a given overbought or oversold level, and then to reverse and change direction.
Please note that ROC is calculated on the Underlying Security and NOT on the option.
The idea is to search for securities identified by ROC as oversold or overbought. We then look to buy calls in securities that are oversold. We look to buy puts in securities that are overbought.
Remember, we are buying options in both cases – oversold and overbought. The difference is – we buy calls in oversold ROC and puts in overbought ROC.
When the Underlying security is falling in price and ROC is oversold, Calls are available at lower prices and hopefully at lower volatility. This is possible since in a falling market Puts are in demand and command higher premium. Thus, we try to buy calls when the calls are not in favor and have lower premium.
When the Underlying security is rising in price and ROC is overbought, Puts are available at lower prices and hopefully at lower volatility. This is possible since in a Rising market Calls are in demand and command higher premium. Thus, we try to buy puts when the puts are not in favor and have lower premium.
What is the definition of overbought and oversold?
We look at a chart and try to identify ROC levels that define these levels. We have used an ROC value of 107 and above as overbought and 93 and below as oversold.
Filter with Historical Volatility
Once we identify Underlying securities that are oversold or overbought using the Momentum Indicator, we should check if the volatility is high. As a rule we should try to avoid buying options when (a) Historical Volatility of the underlying security is High, or (b) Implied Volatility of the option is high. The use of implied volatility is beyond the scope of this article.
We can use Historical Volatility to filter out our ‘buy option’ signals. Trend Analyzer has a Historical Volatility Indicator. Apply this indicator on the Underlying Security. If the HV indicator is near the top then avoid buying options since volatility (time premium) is likely to be high.
Exit Strategy
We are trying to capture short-term moves with this strategy. We want to exit before the option starts decaying in value. The exit strategy is:
1. Exit immediately if the option loses one half of its value. This is the maximum loss that we should incur. Since we are buying the options when the market is at an extreme, this exit method should be invoked rarely.
2. Exit after a strong move in your direction.
3. Exit after 7 days have elapsed. If we still do not have a move in our favor, we want to get out before we lose more time premium on the options.
4. Exit if the momentum indicator gives a signal in the opposite direction.
Example: ACC
The ROC indicator is applied to the ACC chart with the following settings:
Period for ROC: 10
Overbought Level: 107
Oversold Level: 93
From the beginning of 2002, ACC has given 3 sell signals and five buy signals.
A Sell signal is received when the ROC goes above 107 and then falls.
A buy signal is received when the ROC goes below 93 and rises.
After the sell signals, we could have purchased PUT options. ACC fell in the next 5 to 7 days and the Put options were probably profitable. All three sell signals should have given some profit.
After the buy signals, we could have purchased CALL options. Signal No 3 was clearly a loss. Signals No 1,2 and 4 were profitable. The last signal, signal no 5 was either a loss or a breakeven.
The ROC threshold we have used was 107 for overbought and 93 for oversold. We found that the levels gave a reasonable amount of trades and avoided some whipsaws.
You should experiment with these values.
