- February 13, 2023
- Posted by: CoachShane
- Category: Trading Article
Technical analysis is an important part of options trading. It is a strategy that uses past market data and trends to determine the probable direction of future price movements. By studying market trends and analyzing data, traders can make decisions about when to buy or sell their options contracts.
Also, certain market conditions will require a certain type of options strategy. You would use a different options trading approach with a strongly trending underlying compared to an underlying asset that is range bound.
Overview of Technical Analysis
Technical analysis involves studying historical stock market data to identify patterns and trends that can be used to determine the potential of future price movements. It uses chart types such as line charts, bar charts, and candlestick charts, as well as indicators such as moving averages, relative strength index (RSI), and stochastics, which are mathematical formulas used to analyze stock market data.
There is no magic with any trading indicator, but it is helpful to use them to identify patterns and trends. Technical analysis can help traders identify entry points, places to put protective stops, and potential price targets. It can also be used as a tool to decide when to close out profitable trades or cut losses on losing trades.
By combining these tools with observation and research of past trends, traders can gain insight into the direction of market prices.
Step-by-Step Guide to Trading Options Using Technical Analysis
Trading options using technical analysis requires research, observation, and the use of different indicators.
Here are the steps you need to take when trading options with technical analysis:
Research the stock and observe market trends
Before executing any trades it is important to do your research on the underlying stock you’re interested in trading. Some traders will use the fundamentals and financial position of the stock (company). Other traders believe that all data is baked into the current stock price and the chart tells you everything you need to know.
Whatever approach you use, ensure it is done consistently before every trade you take. One simple approach is to observe long-term trend lines to help you identify potential resistance or support levels where the stock may find support or resistance when trading within those ranges.
Use Technical Indicators
Use different indicators to identify key support and resistance levels and the potential direction of price. Different indicators like RSI (Relative Strength Index) or MACD (Moving Average Convergence Divergence) can be used to identify key support/resistance levels at which prices could break out or consolidate. Identifying these points ahead of time can help you formulate strategies that are more likely to be successful when executed properly.
Choose The Right Options Strategy
Which strategy you use will depend on the expectations you have for future price movement.
| EXPECTED PRICE MOVEMENT | STRATEGY TO CONSIDER |
|---|---|
| STRONG DIRECTIONAL MOVEMENT UP OR DOWN? | CONSIDER BUYING CALLS OR PUTS |
| EXPECTING SMALL MOVES OR SIDEWAYS ACTION? | LOOK AT SELLING CREDIT (VERTICAL) SPREADS |
| DIRECTIONAL MOVE + TARGETS? | BUY DEBIT (VERTICAL) SPREADS |
When selecting an option contract it is important to consider both the strike price as well as expiration date (when your contract will expire). Selecting contracts with appropriate strike prices and expiration dates based on your research. Selecting the right strike price will give you an edge when looking to not only enter the trade, but also with your decision to exit.
Options Trading Example
Imagine that the company Baker Hughes is on our watchlist and we notice a few technical clues:
Price is in an uptrend and was involved in a pullback on our trading time frame. The moving averages have caught up to price and we see price whipping around the averages. This shows us that we are in a consolidation.
We notice that we have a flat top put in with relatively equal highs forming a resistance level. At the same time, price is making higher lows into resistance and we believe this is a bullish sign. We consider the volume and note that volume has decreased while price is forming this range. We can also see that price has room to run to the upside before hitting potential resistance
For simplicity sake, imagine we are expecting a strong move up in the next few days due to the very low volume and recent price action failing to move much lower. If we were considering a small move or even continued range bound price movement, we’d look at selling credit spreads.
We decide to buy an in the money call option using the $28.00 strike price with an expiration 23 days out. Imagine we get filled at the mid price of the bid and ask price or $1.55.
To enter using one options contract would cost us $155.00. If we were to purchase the shares (100), it would cost us $2865.00. We need price to surpass strike + premium or $29.55 for us to make money on this trade.
Once all other factors have been considered it’s important that you execute your trade based on sound strategies grounded in technical analysis principles. We can’t ignore risk management techniques or hedging strategies that are designed for specific scenarios such as bearish markets or bullish markets. Knowing how best to manage risk before executing trades will give you an edge when and if price does not behave as you expected.
Summary
Using technical analysis is a huge help for you to determine the evolution of price in the underlying instrument. By having the probability of one thing happening over another, you can then position yourself with some basic option strategies including the simple call and put buying. Whether you use technical indicators such as the MACD and moving averages or simple simple trend lines and chart patterns, having a set methodology for trading is vital.
As you progress in your options trading, you will want to learn a lesson from Mike and branch out into other strategies and improve your bottom line.
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