Option Barrier Trading



Option barrier trading offers simple opportunities for the beginner to apply the order flow trading mindset. It basically reduces the thought process to deciding who is stronger, the option attackers or defenders. As an added benefit, the stop loss or take profit level is usually defined.

While determining who is stronger, here is a rough guide on what to take note of:

Sentiment

You want to know if sentiment is strong, mixed or weak if possible. This affects attackers and defenders both.

Average daily range (ADR)

When prices have already moved their ADR, it is unlikely that they will continue unless some extraordinary events are happening. It can be chart related or fundamental. This helps determine the strength of the attackers.

News

News trading is a subject by itself. It is much easier to play the news when it causes price to approach a barrier though. You just need to determine if the order flow from unexpected news is strong enough to continue its move to overwhelm the defenders.

Strong technical area

Confluence of technical area such as support/resistance, Moving Averages and key Fibonacci levels helps strengthen the defenders.

Time of the day

This has an effect on the motivations of the attackers. As a rule of thumb, active periods such as trading sessions overlap gives strength to attackers while lull periods favors the defenders.

How often the barrier had been attacked

The more times the barrier has been approached, the weaker the defenders. As a rule of thumb, I often find the third attempt with suitable conditions extremely conducive for the attackers.

Price

You also want to note how price are reacting when it approaches the barrier for some clues and confirmation to the strength of the attackers and defenders.

How these factors interrelate should become clearer with some examples.

Example 1: ADR/option barrier combination fade on GBPUSD (9th July 2013)

The cable has been moving down since the release of a worse than expected Manufacturing Production m/m (-0.8% vs 0.3% expected) from a high of 1.4980 to a low of 1.4812 (168 pips) approximately 5-6 hours later.

Here are the facts that you have around 1430 GMT,

Possible thought process: Existing sellers are probably exhausted for the day selling the unexpected negative news release for cable. It is doubtful that there are new sellers willing to enter at this point in time (at least until the start of Asian session) to try and break 1.4800. This is the first approach of price to the barrier, hence it is likely that the barrier defenders are strong. There are probably other buyers that will help in protecting the barrier.

At this point, I think it should be obvious that defenders have the upper hand. So a fade trade can be made as soon as you see buyers starting to step in on the price chart, with the safest stop loss just beyond 1.4800. It is always good to stay flexible and a good plan B is just to bail if the defense look weak through the price action.

Chart 1 (Time is GMT +8)

Example 2: option attack on the back of news (EURUSD 13th March)

Here are the facts you have after better than expected retail sale m/m (1% vs 0.5 expected)

Possible thought process: Defenders have been weakened through repeated attempt to break the barrier for the past few days. EURUSD looks weak overall compared to other similar pairs. The retail sales m/m, although not very spectacular, should provide the additional fuel to break it. I should prepare to bail if defense looks strong as price gets nearer to the barrier.

Chart 2

Note: I personally took a trade on this as a news trade leading to barrier attack. I closed my position at 1.2985 and entered again at 1.2975 as the failure to break 1.2985 to the upside makes defence seems weak and the break imminent.

Example 3: option fade on the back of news (EURUSD 14th March 2013)

Here are the facts after some data releases with most of them as expected while unemployment claims are better than expected (334k vs 350k expected)

Possible thought process: Barrier defenders are fresh and strong, being the first time that price is approaching the barrier. EURUSD looks weak but not as bad as the day before indicating weakening attackers. The unemployment claims data are also not spectacular enough to entice more sellers to enter. Fading the data release before the barrier seems like a good choice.

Note: The reason why I chose this example is to contrast it with the previous example not just in price reaction when approaching the barrier but also the subtle interplay of the various components in determining strength of attackers and defenders.

Chart 3

Conclusion:

Option barrier trading is not as straightforward as always pushing or fading the barrier. It is simple in idea as it usually reduces down to understanding the motivations of 2 major market participants.

Always keep in mind the various factors while trading barriers as much as possible. They are also things that you consider in other forms of order flow trading.

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