From the Archives: The Zone System

Each Wednesday we'll reach back into our 25-year archive of commentary by our founder, Jim Yates. Here's an excerpt from 1994's The Yates Guide to Profitable Options Investing:

The Zone system is based on an analysis of the deviation of a stock's price from it's trend. Zones are the six areas under a normal bell-shaped curve defined by standard deviations. Zone 1 represents the area that is between two and three standard deviations below the mean. Zone 6 is at the other extreme. Zones 1 and 6 are the farthest points from a stock's mean, or where it has historically migrated during reversion to the mean. The mean is the vertical line bisecting the normal curve and it's called the trend.

Because it's future distribution we're concerned about, the implied volatility for the stock is used to estimate that standard deviation. Implied volatility is the annualized standard deviation that justifies the current options price. This is a particularly important statistic because it's the only market-derivable statistic that represents a forecast of future price movements.

We use two time frames for analysis, 10 days and 90 days. There's nothing magical about these two time frames, they were chosen because they fit the profile of a short-term trader and options hedger.

In the process of the evaluation, each Zone is expanded to a 33-point scale. A stock that is at the three standard deviation limit, or Zones 1 and 6, could then be said to be either 99% oversold (Zone 1) or 99% overbought (Zone 6).

The beauty of the Zone system is that it's easy to use. By simply identifying which Zone a stock's in, you can formulate a strategy. Next week we'll describe a tool we've named the Options Strategy Spectrum. The similarity between the Options Strategy Spectrum and the normal distribution curve is no coincidence. They're the same, but we've broken down the bell curve into Zones that delineate which stock-and-options strategy is appropriate at the time. Zones 1, 2 and 3 are below the mean (or oversold), while Zones 4,5 and 6 are above the mean (or overbought).

The Zone system is simply another way of looking at the market, but from a risk perspective. One advantage of the system is that it allows direct comparison of the overall market, market sectors and individual stocks at the same time. Every market index, sector index and individual issue will visit each Zone over the course of time. When issues move to the extreme Zones, the probability is high that the next move will be back toward the mean, assuming the volatility estimate delivered by the market proves reliable.

The Zone system can be compared to a map. While a map may be of significant benefit in determining where you are headed, it's most important contribution is detailing where you are right now. If you don't know your current location, it's nearly impossible to locate the path to your desired destination.