The Way the Wind Blows

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Knowing the velocity of the wind is only part of what Orville and Wilber Wright needed when they first took off at Kitty Hawk. The also needed needed to know the wind’s direction.

Implied volatility (IV), only tells us how much the price of the underlying is expected to change. Of course, we want more than that. We want the expected direction of the change, but the best we can do is to make an educated guess.

We make many educated guesses throughout our lives. Our guesses may begin with the assumption of a standard distribution on the outcome of some event. A baseball player has a .300 batting average, so we expect that he’ll get on base a little less than a third of the times he’s at bat. But there may be particularities that will shift our expectation. We might want to know how well he has done against a certain pitcher, or in a particular stadium. We may consider the effect of a recent injury or layoff from the game. The pricing model for options assumes a normal distribution in price variations, and that’s a very suspect assumption. To find perturbations in volatility, traders often turn to price charts.

Divining how the price of an issue may change by looking at the charts gets into the area of technical analysis, something that you’ll find a lot written about. The vocabulary is extensive and intimidating: dojis, engulfing candles, cup and handle, double-top, head and shoulders, Fibonacci retracement–and who knows how far this list goes on. I’ve come to doubt that there is anything intrinsically predictive about any of these patterns. What matters is that other traders buy into them, and so they become self-fulfilling proficies. If you’ve played with the aggregation settings on price charts, you know that the patterns you see on a 5-minute chart differ from those on a 1-week chart. So look at the chart that most other traders of the options you’re interested in are using.For expirations between 5 and 50 days, most will probably be attending to one-day aggregations over a period of three to six months. Those who want to exit a trade the day they open it will probably use 1 to 5 to 15 minute aggregations. As we noted in an early post, you may be able to identify levels of support and resistance that give insight into the ranges traders expect. You might also use an indicator such as the directional movement index (DMI) indicator, which attempts to quantify how the stock is trending. You should take time to study other indicators as well.

Many traders pay attention to moving averages and various indicators based upon them. Because they’ll often make judgments about issues based on these indicators, you might look at some of the more popular ones as a way to gather insights into how they’re evaluating the underlying issues. Changes in volume associated with movement in such indicators might suggest how strongly traders are buying into this movement in the indicators.

Key take-away: To make an educated guess about which way a stock will move, look at price action the way other traders are looking at it. Know which way the wind is blowing before you take off.