Projecting Market Range for Options Strategies Using ODI

There may be anunlimited number of approaches to the markets and their usefulness may be bothobvious and questionable. As mass psychology is a basic engine which drivesmarkets forward, so the analysis is derived from market psychology and as suchit may seem more attractive than it actually is. On the other hand soundanalytical methods do not get significant attention at times, as they areeffective but not necessarily “promising” and give traders the truth, whichsometimes may be hard to accept.

In the March 2005edition of “Futures” magazine the ODI (Option Deviation Index) was presented,which takes measure of market fluctuations based on the entry point (Fig.1). The result is calculated as a percentage of entry value divided intonegative, positive and closing series. Based on this assumption we can createvarious time models showing statistical dispersion of the index readings.

In the  previously described example we used the ODIconcept  in calculating the TotalPeriodical Deviation (TPD) obtained as:

TPD = H% + L% + C%

Where:A – beginning of the measured period of timeB – end of the measured period (expiration day)H% – the percentage difference between the highest price and the starting(point A) price L% – the percentage difference between the starting (point A) price andthe lowest priceC% – the percentage difference between the starting (point A) price andclose of the measured period (close on the expiration day)and the resultwas smoothed out with simple moving average (we used MA?s length of 9 in thisexample) and drawn as a single line chart (the ODI line).Since then themarkets have gone through a rough period reaching an all time volatile pointduring the financial meltdown of 2008. In this article we are reviewing the ODIconcept 5 years later after its inception and showing other ideas of applyingthis technique to market analysis.

The ODI concepthas successfully survived the market crash of 2008. In fact, it turned out tobe a helpful tool during periods of extremely high volatility, when commonlyknown techniques had very limited use.

There are manyways of using the ODI concept. The most basic is to analyze Option DeviationIndex using classical technical tools such as MACD or RSI. As the ODI filters alot of market noise, applying these simple methods to the ODI drawn as a singleline can give us a clearer picture of the present market condition.

The simpleexample of this technique is shown in Figure 2. To achieve better long termresults we used the ODI calculation for periods starting on the first sessionof the month and ending on the following month?s expiration day drawn as asingle line with Relative Strength Index (with classical length input of 14)applied to the chart. Both bear markets of the last decade were clearlyrecognized by the study. In addition, this picture allows for a clearidentification of divergences between the ODI line and RSI oscillator both inthe years 2000 and 2007, early enough to be prepared for the downturns whichfollowed these turning points.

However, thebiggest advantage of using analysis based on the ODI concept is in forecastingthe range of the underlying index (S&P500) in separate time segments. Forillustration of this ODI usage, we chose a model period between option`smonthly expiration dates, although any other length may be used as long asentry and exit points follow the same selection rule through analyzed data.

As our modelneeds to be engineered to work on the S&P500 futures options our periodsstart at the opening of the first session following expiration day, which isevery third Friday of the month and end on the close of the next month`sexpiration day session. By using calculations shown in Figure 1 we can simplydraw a bar chart of analyzed periods to create a statistical picture of marketactivity (Fig. 3).

Even apreliminary observation without performing complex calculations would give ussome idea about projected market range e.g. it is not so difficult to analyzegeneral probability of the market reaching the 6% percent level up from thestarting point during the single analyzed period (expiration to expiration inthis case), which for the period between April, 19th and May, 21st2010 equals approximately 1203.54, neither projecting chances for the marketdrop to 1110.96 level (4% down respectively). This is all calculated on entrypoint basis, which equals the open price on April, 19th session(1157.25).

This approach tothe market activity analysis was named Option Deviation Index Diagram for manyreasons, such as:

  1. The ODIDiagram is a better tool for projecting market range rather than particularvalues or levels, because it corresponds more accurately with option tradingstrategies than commonly used charts
  2. The Diagramgives a better perspective for option trading as it separates periods of timesequal to options? “lives”, which eventually end on the expiration day. Insteadof the sample period (expiration-to-expiration) used in the study, it can betailored for any other time frame corresponding with the employed strategy.
  3. The ODIanalysis diagram takes a significant part of the “chart psychology” out. Forany experienced trader the commonly used price charts e.g.  bar chart, candlestick chart etc. bring alot of information per se, as it is related to the trader?s professionalknowledge such as technical analysis patterns and formations processed withone?s own personal experience. This amount of information creates significantpsychological pressure affecting the chartist, whose primary goal is still toanalyze and forecast market direction. As most option strategists are ratherinterested in measuring market range and/or volatility projection, the ODIDiagram can work better for them by creating a clearer picture of what may beexpected in the markets.
  4. The conceptis very simple, and for the same reason it is reliable. The ODI diagram doesnot attempt to claim any technical formations and because of that it simplyprojects the market?s range, which in turn shows certain regularities.

Another advantageof market activity presentation in a form of a diagram is volatilityprojection. As we analyze market activity during the defined time, the diagramgives us an additional sense of market velocity. For example we can see how themarket overreacted in the year 2008, followed by reverse action in 2009.

Application ofthe ODI concept to the diagram results in “Percentage levels tree” as shown inFig.4. The “Tree” would show possible scenarios of market action during the “life”of a particular option starting from the entry point, the opening price on theMonday following the third Friday of the month, April 19th, 2010 inthis example. By calculating percentage range taken from the starting point weobtain a “map” of strike prices which may be used for a specific optionstrategy. And if we trade directional strategy and want to use options forhedging our position, the “Tree” may help as well.

Chris Marczak can be contacted at Unisystems

Price Action Trading Strategies (Beyond Price Patterns)

Live Trading Floor – November 2013