Splitting A Range To Find Levels For Put And Call Options
In today’s article, we will be explaining using Fibonacci retracement tools in range bound binary options trading in order to find the appropriate levels for put and call options. Specifically, we will be discussing how to use the Fibonacci retracement tool to identify when to use the traditional high/low option and when a one-touch option would be a better choice.
Identifying a Trading Range
The first thing a trader has to learn is how to identify a trading range. This is when the price movement of an asset is stuck within a certain range; this is also known as an asset being ‘range bound’. In range-bound trading, the price of an asset is said to be moving sideways. The best way to identify a trading range is by a visual analysis of a chart.
The above is a basic example of an asset that is currently range bound; the top line is known as the ‘resistance’ level and the bottom is known as the ‘support’ level. To fully determine if the asset’s price is range bound, there must be at least 2 high points and 2 low points with the highs and lows being parallel to each other.
Range Bound Trading Risks
Since an asset that is range bound creates predictable price movements, it is possible to formulate profitable trading strategies subsequent to identifying a trading range, such as with the Fibonacci retracement tool. Before we delve into that, we must first elaborate on the main risk of range bound trading; namely breakouts.
A breakout occurs when the price of an asset, instead of merely testing the support and resistance levels breaks through them. This can leave a trader holding worthless options; for example, if a trader buys a put option when the price nears the resistance levels in anticipation of a price drop but the price breaks out of the range and keeps increasing instead, then the put options are rendered worthless. Similarly, if a trader buys call options when the price nears support levels in anticipation of a price increase but the price breaks out of the range and keeps decreasing, then the call options are also out of the money.
Further, there is no real way to determine when such price breakouts will occur, and many traders have been left holding worthless options in such cases. As we have repeatedly stressed, there is no such thing as guaranteed strategies in trading; even the most technically sound trading strategies will not and cannot be 100%.
Splitting a Trading Range Using Fibonacci Retracements
Price breakouts aside, as long as the asset is still range bound; there are definite opportunities for profitable trading. While the strategy seems obvious – call options near support levels and put options near resistance levels we will go a little deeper than that.
First, the theory behind Fibonacci retracement levels, which are all based on the ‘golden mean’ of 1.618 or its inverse, 0.618. There are 5 Fibonacci retracement levels to know: 23.6%, 38.2%, 50.0%, 61.8%, and 76.4%. For background reading on the brief history of the Fibonacci sequence and the source of the various Fibonacci retracement levels, this article is an excellent resource.
Let’s take a look at our previous chart example, but now with the Fibonacci retracement levels mapped out. Note that this is just a rough visual example, and further, for the purpose of this range-bound trading strategy, we are excluding the 38.2% and 61.8% retracement level. A good trading platform should come with a built-in Fibonacci retracement tool option.
So, in terms of call and put options, whenever the price of the asset is between the 0% and 50% level, the lower half of the range, we will be looking at purchasing call options and when it’s between the 50% and 100% level, the upper half of the range, we will be looking at purchasing put options. This is the most basic strategy at the heart of range-bound trading and the 50% level represents the first split in the range that we can utilize.
Now we split the range even further, utilizing the 23.6% and 76.4% retracement levels to determine the best type of option to use in the situation. The general rule is the following: when the price touches the 23.6% level or the 76.4% level, we will be looking at purchasing one touch options with the strike price of the one touch option being the 50% retracement level. One the other hand, when the price of the asset touches the support or resistance levels (0% and 100%) then we will be looking at the traditional high/low options (calls and puts, respectively) with longer expiration dates. Let’s illustrate this on our chart once more (using only the lower half of the range to avoid visual clutter).
If you would like to split the range even further, then the 38.2% and 61.8% levels can be reintroduced. Note for instance on the second ‘one touch’ level from the left of the chart that depending on your expiration date, the price may not reach the 50% level, however it would have reached the 38.2% level. We can see this also at the top half of the chart where at certain points when the price touches the 76.4% level that a strike price at the 61.8% level would have been more appropriate.
While Fibonacci retracement levels are an excellent technical analysis tool in range bound trading strategies, it is not the be-all-end-all or even 100% certain. Nevertheless, it is an effective tool in a trader’s arsenal and all traders should at least have a surface level knowledge of Fibonacci retracements.
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References and Further Reading:
- Put and call options: a theoretical and market analysis (Kruizenga, Richard John)
- The pricing of call and put options on foreign exchange (J. Orlin Grabbe)
- Put-call parity theory and an empirical test of the efficiency of the London Traded Options Market (Mary Nisbet)
- THE VALUATION OF AMERICAN PUT OPTIONS (Robert C. Merton, Michael J. Brennan, Eduardo S. Schwartz)
- Upper and Lower Bounds of Put and Call Option Value: Stochastic Dominance Approach (HAIM LEVY)