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Maximizing Technical Analysis with Options Trading

Tony Zhang
August 6, 2019
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Maximizing Technical Analysis with Options Trading

As a market strategist and practitioner of technical analysis for over a decade, I have spent my share of time studying indicators, price patterns and trading strategies. Having worked with thousands of clients on technical based strategies, I find that the most important aspect of trading is trade and risk management. Unfortunately, technical analysis only provides an outlook, not an actual strategy to manage risk and our trades. In order to maximize the value of technical analysis, we need to express market outlooks efficiently with our trading strategies. In this post, I explore the benefits of technical analysis through the lens of option strategies, to illuminate the most efficient way to deploy your capital for various methods of technical analysis. To learn more about Maximizing Technical Analysis with Options Trading, please view our webinar recording.

What is the Value of Technical Analysis?

Technical analysis is the study of price history to forecast price movements and what is likely going to happen in the future. Technical analysis can be used to assess 3 important factors for trading:

  • Direction – Will the stock move higher or lower?
  • Magnitude – How much higher or lower will the stock move?
  • Timing – How long will a move higher or lower take?

Benefits & Limitations of Technical Analysis

Technical analysis is extremely flexible, as the methods can be applicable to any tradable instrument with a price and can be used on all time frames, whether it be a 5 minute currency chart (day traders) or a weekly stock chart (long term investors). This allows for a single technical analysis methodology to be applied seamlessly for intermarket analysis on any timeframe. However, it is important to remember that there is no such thing as a best strategy or best indicator. Personally, I found that what separates successful traders from the rest, is not what indicators they use, but how consistent they apply the same indicators each time they trade.

Option Strategies for Technical Analysis

Traders tend to spend a disproportionate amount of time studying charts and indicators to speculate on the direction of a stock, but spend just a few seconds on risk and trade management. While the direction of the stock is an important factor to consider, the magnitude outlook should be considered when determining what trading strategy will provide an efficient risk/reward ratio. For example, when analyzing the outlook of a stock, if there is a:

  • Clear direction but unclear magnitude

  • Clear direction and clear magnitude

We will explore different methods of technical analysis and show how each of these 3 options strategies are suitable, with magnitude providing guidance as to the most efficient way to deploy your capital.

Price Analysis and Patterns

Support and Resistance lines

Support and resistance lines (or zones) are areas where prices have repeatedly reacted higher to (support) or lower from (resistance). As shown in the chart below, a support and resistance range provides investors with a sense of direction and magnitude with the support and resistance levels. In these cases, debit vertical spreads provide a directional trade with the least amount of risk. For example, if the price has rebounded off a resistance level and is heading towards the support level, an efficient trade would be to buy an “in the money” put near the resistance level, and sell an “out of the money” put near the support level.

Chart 1: Support & Resistance

Source: TradingView

In the case where price hesitates around a support or resistance level and the sentiment has changed to a neutral outlook, credit spreads would be a better strategy to use with an unclear magnitude outlook.

Breakouts and Breakdowns

A breakout occurs when the price surpasses a previous resistance level and rallies higher, while a breakdown occurs when the price breaks below a previous support level. This provides a new directional view, however, there may not be a clear sense of magnitude, especially with breakouts to new all-time highs. Since most breakouts and breakdowns tend to move quickly, buying a call or a put option typically is a suitable strategy. In the case of a breakdown where the previous support provides a target price, buying a put debit vertical spread is a bearish option strategy with a good risk/reward ratio.

Chart Overlays and Indicators

Lagging Indicators – Moving Averages and Bollinger Bands

These indicators are based on previous average prices to help forecast what may happen in the future. One such popular strategy is the moving average crossover. Moving averages can act as a dynamic support or resistance level as shown on the chart below. When the price moves above a moving average, sentiment may change to a bullish stance and vice versa. However, it is paramount to remember that the moving average crossover strategy only provides an outlook based on direction but does not provide any metrics for the magnitude of the move. In this case, buying , shorting the stock or  selling credit vertical spreads typically are better suited for this trading strategy. However, buying longer dated (greater than 6 months) calls and puts can also be an option as this provides a long enough time horizon for an investor to catch an extended move.

Chart 2: Moving Average

Source: TradingView

Bollinger bands on the other hand,  are typically used as a mean reversion strategy, providing signals that the current price has moved too far from its average price. When the stock exceeds its Bollinger band, a retracement is usually expected, and this gives a clear sense of direction and magnitude as shown below. In this case, buying debit vertical spreads provide a strong risk to reward trade.

Chart 3: Bollinger Bands

Source: TradingView

Leading Indicators – MACD, RSI, Stochastics

Leading indicators are by far some of the most popular indicators used by investors. These indicators are used to track the direction and velocity of momentum and typically used to generate signals based on changes in momentum. A common mistake in applying leading indicators, stems from the fact that these indicators provide a clear sense of direction but provides no guidance for magnitude.

Chart 4: Leading Indicators

Source: TradingView

Leading indicators are often misused by traders as the signals are taken as indicators to go long or short a stock, without a sense for how far that stock can move. Due to the lack of magnitude outlook that leading indicators provide, selling credit spreads provide a better risk/reward for these higher probability signals. This is because, if a momentum indicator signals that a stock is overbought, that only indicates it is unlikely to continue higher, but not necessarily reverse lower. Selling credit works best as there is a more neutral sentiment, due to the fact that it is unlikely for a stock to move much higher when it is overbought.

Summary

Technical analysis provides an objective view on all tradable assets and instruments when applied using a methodical approach. However, it is more important to consider the risk and rewards of each trade that you take, given the trade is how you make or lose money. In order to  structure each trade with the least amount of risk for the outlook that you have, it is important to consider your magnitude outlook and factor that into which option strategy is suitable. Please view our webinar recording on Maximizing Technical Analysis with Options Trading for more information on this topic.

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx

 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

 

The 12th annual Options Education Day in collaboration with the Options Industry Council (OIC) will take place in Toronto on September 14, 2019 at the Westin Harbour Castle. Seats are limited, so sign up before August 19 for the early bird pricing! To learn more: m-x.ca/oed

Tony Zhang
Tony Zhang http://tmx.optionsplay.com

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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