After offering investing basics in earlier articles about option trading in a series of 29 option spread strategies you need to know, this article will focus on how to determine whether to approach trades from a bullish, bearish or neutral perspective and which strategy to use.
Without going into too many details about technical analysis, a few basic concepts will provide you with sufficient understanding to identify trades with the best potential for high returns on your investment. The two main methods of evaluating markets are fundamental analysis and technical analysis.
Fundamental analysis evaluates companies or markets based on their profit and loss, customer base and the way they conduct their business. When using the fundamental analysis to evaluate a company, you analyze its balance sheet, income statement, market share, sales, product development, etc. Fundamental analysis usually will yield better insights than technical analysis to assess market trends five years or more into the future.
Technical analysis employs a variety of mathematical and graphical tools to evaluate the share price and its moving averages, volume, open interest, relationships between different markets and relationships between securities and indexes. Most option traders who engage in short-term trades focus on technical analysis.
Technical analysis generates more controversy than almost any other aspect of financial trading or investing. Some people claim that technical analysis is entirely useless. Some claim that, while not useless, technical analysis can produce conflicting results even for the same market conditions. Yet, others will swear that technical analysis is the only reliable tool to gain insight into investment markets.
I have used technical analysis regularly and successfully to determine when to go long and when to short the market. Some traders used technical analysis to anticipate the bursting of the NASDAQ bubble and got themselves and their followers out of the market well before the collapse.
I believe that for short term market assessment, technical analysis will provide more accurate insights than fundamental analysis almost every time.
While several schools of thought exist under the technical analysis umbrella, I will focus only on general concepts that will be applicable across virtually any type of trading. These tools do not require years of study to master. They are simple to use, quick to execute and relatively definitive in terms of their direction.
Before explaining the analysis method, I will briefly define a few key terms and definitions that are necessary to effectively use the tools.
Basics of Trend Analysis: Macro, Micro, Mini:
A trend is a general direction in which an observed variable moves. If the price of Google was $800 on February 2, 2017, then increased to $807 on February 7, 2017 and finally rose to $809 on February 9, 2017, the trend for Google is up, or bullish.
Macro trends are long-term trends; usually from 18 months to 5 years and sometimes longer.
Micro trends are short trends that last for as little as few months to perhaps 18 months.
Mini-trends occur over a very short period of days, weeks or months, at the most. While some day traders look at minutes, I will not cover that style of trading.
Macro and micro trends are not very useful to this form of options trading. Mini-trends are what will make or break us in our option trading strategies.
There are thousands of different charts that can be used to analyze the options and their underlying securities. However, I will focus on two common types of charts only. A simple line chart and a bar chart that shows the opening price, the closing price, the high price and the low price are all you will need to determine your options strategy.
While various candlestick charts, point-and-figure charts and similar kinds of charts can be useful for certain types of trading, you usually can obtain the same insight with simple bar charts and line charts.
When analyzing charts, we are looking for concepts called resistance, support, moving averages, trend lines and trend channels.
Resistance is the point where a price or volume figure has attempted to surpass a level and has bounced back.
Support is where something has bounced down to that level and may turn up again.
Moving averages are calculated on a variety of different methods where we are looking for the overall average of a long-term series, such as prices or volumes.
The picture below illustrates some of these terms.
A trend line is drawn from one point of a line along the time axis to another point of the line. It is a straight line between at least three points. When that trend line is broken, this often defines a new trend in the opposite direction.
A trend channel defines the high and low points of a price or volume line as it moves up or down in a trend. A break outside of the trend channel can signify a change in the trend.
The relationship between the macro-trends, mini-trends, and micro-trends is very important. The highest probability of a positive trade exists when all three trends move in the same direction. If the mini-trend is trading opposite the macro-trend or the micro-trend, we must be confident that our technical analysis lets us know exactly how long that mini-trend is going to last.
In a future article, I will describe moving averages in more detail and explain how to use these averages to determine trends, as well as how to identify trend reversals, trend tops and trend bottoms.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.