A reminder on the Rule of 16

The Theory:

There are around 252 trading days in a year. The annual volatility can be calculated as Sigma = Sigma(daily) * Sqrt(days).  Typically traders use 256 as the number of trading days, because often decays happens during non-trading days anyway, and also because Sqrt(256)=16 which is much easier to figure out in your head.

You can use this in two ways:

  • Bollinger channel -> Daily -> To expiration:
  1. Bollinger channel width is typically 2 sigma. You look at a chart and see that the channel is $170 – $120 for a $154 stock. (Actually my example is an ETF, less subject to market maker manipulation).  XBIChart1
  • XBIChart2Convert this to a volatility estimate. The Bollinger channel is usually 2 sigma. In this case, this is what my FreeStockCharts setting is.  Sigma(20) is thus: ($170-$120)/(2*$154)= 0.71. In percentage it’s 71%.
  • Because this is a 20 day sigma, estimate the daily: 1.0 + 0.71 (the multiplying factor for 20 days) and to the daily
    DailySigma = Sqtr ^20(1.71) . Use the Square root with a superscript key on your calculator. You should get 1.02718. this is 2.718% daily.
  • You can estimate the annual volatility by multiplying by 16, because the correct formula is: 2.71 * Sqrt(252) but really can be approximated by 2.71 * 16 = 43.36 % Yearly.
  • Really, we’re just trying to get at the expected stock price within the expiration timeframe of 27 days. Using the similar formula for 27 days instead of 252: 2.71 * sqrt(27) = 14%
  • Implied Volatility -> Annual -> To expiration:
    • XBIOptionsThe other way to get at the expected volatility until expiration is to estimate it based on the Implied Volatility from the options premiums. The platform I used here is TradeKing, but all platforms use similar techniques to estimate it. The IV is an Annual volatility value. So let’s look at the $154 Put with an IV of 35.16.
    • The next step is to figure out the daily: 35.16/16 [Yep it’s that easy] = 2.19 %
    • Finally we can estimate the volatility between now and expiration: 2.19 * sqrt(27) = 11.37.

    So now we know, the volatility expected from the premiums is around 11% and the volatility from the past 20 days is 14%.

  • The two conclusions we should draw from this are:
    • The option premiums are low. Consider buying, not selling premium. This is especially important considering the Stock Market too a large dive on Friday, and the ETF I chose for this illustration is a Biotech ETF, one that has been strong over the last 3 months, and plunged 3% when the market plunged 3%.
    • The second conclusion is the expected hi/lo limits by expiration. If you buy the put, obviously, you want to know the top and bottom expected prices. Splitting the difference at 13% the expected move within 27 days is around $154*13% = $20.

    So here you have it, premiums are low, and the $154 Put is cheap, even at $5.50-$6.60 if the past volatility continues, with an expected move of $20 maximum. Because the 200 day moving average is almost $20 below the current price, it’s a pretty good bet that the Put will be in the money by at least $6.

  • If $5-$6 is too expensive for you you could buy the $150 or $148 Put. But I would not go much below that, because the further out you get the more you become exposed to a volatility crush.

About smartmillion

My name is Anthony. I am 45 years old and I am broke.
This entry was posted in Personal Finance. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s