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The Volatility Edge in Options Trading the Cup with Handle and Squeeze Combination

Those of you who have watched our webinar on options trading the cup and handle with squeeze combination may be interested in a more in-depth analysis of the theory behind why this trading strategy can be successful.

You may know that most options are priced using the Black Scholes model which uses as inputs the current price of the underlying stock, the time to expiry, risk-free interest rate and volatility. For the trading strategy discussed in our webinar, using in-the-money call options, we want the strike price to increase after we have placed our trade. For this to occur we want the underlying price to increase which will increase the volatility which will feed back into the options pricing model thereby raising the strike price and our ability to sell our call option at a profit.

The value in combining the cup with handle pattern and the squeeze is that:

• we know that a breakout from a CwH pattern is successful about 60% of the time since 2008 (see newsletter 3/15/14) - more in a bull market. This gives us a favorable probability that the underlying price will rise
• a squeeze situation ensures that the stock is at a historical volatility low so the volatility is highly likely to increase as the underlying price increases.

The combination of rising price and increasing volatility combined with the leverage inherent in options trading makes this trading strategy attractive.

Before entering a trade, a further factor to consider is whether or not the option is fairly priced. This will depend on the volatility implied by the strike price as compared to the true volatility at the time. At this time, our charts combining the Bollinger Band (BB) and Keltner Channel show the volatility as measured by the two standard deviation BB. It should be understood that this is not the volatility implied by putting the strike price (and other variables) into the Black Scholes model and cannot be used to determine if the option is fairly priced. We may add the true volatility to the charts in the near future to allow this comparison to be made.

I am grateful to a reader for directing my attention to The Volatility Edge in Options Trading by Jeff Augen which examines these considerations in great depth. The Wikipedia article on Volatility and Volatility Arbitrage are also very helpful.