Technical analysis: the hocus-pocus voodoo child of the stock market.
Most people will lump technical analysis in with reading tea leaves, moon phases, and astrological signs. It is nothing more than a made-up science made successful by luck, that is what they say.
But are “they” right?
Even with the rise of machines, the stock market is still heavily traded by humans, and with that comes the baggage of human emotion.
Greed and fear run rampant through the stock market, affecting every decision a trader makes. The best way to see and track a trader’s decision is in the charts. It doesn’t take a masters degree to understand technical analysis or how to read charts. In fact, if you focus on the very simple and important aspects of technical analysis, you can add it to your repertoire and use it for options trading.
Why You Should Use Technical Analysis With Your Option Trading
Fundamental and technical analysis both have their place in trading. A company’s longevity and health should be tracked through their books, their fundamentals, not through technical analysis.
A stock’s day to day movement does not reflect changes in its fundamentals. A company doesn’t change its fundamentals every day, so why does a stock go up and down every day?
Emotions drive short term price fluctuations. If a trader feels good about a stock price, they buy; if not, they sell. Technical analysis is good for projecting a few minutes to a couple of months out. More than two to three months out and technical analysis becomes useless.
You can never use technical analysis to predict a company’s earnings report. The market and the company don’t care about what the charts say is going to happen.
Most option trades are going to be short term trades. There is a reason that weekly options have become popular, and that there is a constant call for daily options. Yes, there are LEAPS (Long-term Equity Anticipation Security) options, but they are not heavily traded.
LEAPS are options that expire over nine-months out. They are there to act as a stock replacement, so they should be traded with fundamental analysis.
Normal options can’t rely on fundamental analysis because they are not around long enough to matter, so we must rely on technical analysis. We can use technical analysis to pinpoint entry and exit points with our options. We will also use technical analysis to help decide on the correct option strategy.
Why Technical Analysis Works
As you trade, you will experience a wide range of emotions, it’s inevitable. From the happiness of closing a winning trade, to the sadness of taking a loss, you will go through the full spectrum of emotion. You will question your life decisions, sometimes wondering why you ever started trading in the first place, other times thinking you are on top of the world and were born to be a trader.
Fear and greed will be the two main emotions that drive your decision making. It doesn’t matter if you are making your first trade or your thousandth. There will be no escaping fear and greed.
Technical analysis works because everyone must deal with fear and greed, and it is something we can see in the charts. Human tendencies don’t change, and once you learn what they are, you can trade them.
Support And Resistance Levels
Picture it, you see a stock running from $40 to $50. You decide you don’t want to miss out on this run so you purchase it at $50. As soon as you buy, the stock begins to drop, at first; it drops a couple of bucks. Then the selling begins to pick up steam $45, $40, and then $35. You could close the position and take the loss but you think it might come back so you hold. The stock keeps at $35 and you begin to wonder why you ever started trading to begin with. You knew you shouldn’t have taken this position, and you curse the day you did. Just as you are about to completely give up, the stock begins to climb.
At first it moves slowly and you begin to get hope. First $40 and then $45. Now you can really see the losses go away. You think you can turn a profit on this position. The stock hits $50 and you finally remember why you got into this stock market game. Unfortunately, it never breaks, instead it begins to sell off again. The happiness fades to a depression as your losses begin to rack up again. Over the next couple of days, the price begins to hold but makes another push to $50. This time instead of hoping for profit you just want to breakeven. You sell the stock at $50 only to watch it rocket past $50, missing out on all the gains.
What you just read is what happens to traders all the time. People get their orders caught in these price zones and it creates support and resistance levels.
A resistance level is a price level that the stock cannot break above. The stock will tap the resistance level multiple times without being able to break through. At these levels, you will find that the sellers outweigh the buyers and drive the price lower.
A support level is a price level that the stock cannot break below. The stock will tap the support level multiple times without being able to break through. At these levels, you will find that the buyers outweigh the sellers and drive the price higher.
Support and resistance levels become stronger the more time they are hit. Once these levels are finally broken you can see the price really begin to run.
What Technical Indicators You Should Use
Every broker and “guru” has a custom set of indicators that you should use. They say if you add enough indicators to your charts you will be able to see the answer clearly.
Unfortunately, too many traders believe that hype. No matter how many indicators you add or custom ones you build, there will never be a set that gives you the perfect time to buy or sell. The majority of indicators are going to derive a number using price and/or volume.
Is it better to study the indicator or price and volume?
We use a small selection of indicators in our own charts. The first set of indicators you should use is moving averages. A moving average is the average closing price based on a set amount of days. We use three different moving averages: 20-day, 50-day, and 200-day.
A 20-day moving average will take the average closing price over the last 20 days and draw a line on the chart at that price. It is a moving average because it will only use 20 days’ worth of data. When another day closes, the moving average will drop the oldest day in the data and add the new day. The same goes for 50-day and 200-day moving averages.
Moving averages provide two key pieces of information: trend, and support and resistance.
Don’t fight the trend. Fighting the trend is the equivalent of pushing the boulder up the hill. Yes, you may get it up there, but there will be challenges. Instead, you will want to trade with the trend. You may be wrong about your assessment on stock direction, but the trend could still pull it that way.
Your 20-day moving average is going to set the short-term trend. Short-term trends are good for assessing what is happening right now. It will be key for fast day trades or trades that last only a couple of days.
The 50-day moving average will be your intermediate term trend. This should be your main moving average as option trades typically last a couple of weeks.
The 200-day moving average is your long-term trend. This is a good trend line to get an overall barometer of the market. Since you have 200 days’ worth of data the 200-day moving average is going to be slow. It does not turn quickly and does not react to sharp or fast movements in price. You can use the 200-day moving average as your bull/bear indicator. We judge a bear market by the price action being below the 200-day moving average. Under this level, you will see volatility rise and intraday movement rise. It is at this level that you see a lot more 1-3% movement days.
A moving average does nothing special. In fact, you can see trends by simply looking at the price action over the last couple of weeks. You can clearly see an uptrend or downtrend, especially if the stock has run up over the last week.
Can you see the intermediate trend happening over the last couple of weeks? Yes. Moving averages don’t show you anything you can’t see by looking at the price. They simply make it easier.
Understanding the overall trend is good, but it is not the only job of a moving average. Moving averages are watched by so many traders that they become self-fulfilling prophecies in terms of support and resistance. That means, so many technical traders watch them that they will use them as support and resistance in their trading.
You should ignore the 20-day moving average as a support and resistance point. There isn’t enough data in that moving average to make it a viable support and resistance.
The 50-day and 200-day moving averages should be used as support and resistance areas. These moving averages are watched by the greatest amount of people. Even the talking heads on TV will mention the 200-day moving average. You will typically see a stock bounce off these points before finally breaking through.
With moving averages, it is good to add Bollinger bands too. Bollinger bands are a volatility indicator. It consists of a moving average and an upper band and a lower band at a set standard deviation. Standard deviation is a statistical term that measures the amount of variability around a mean.
Standard deviation is non-directional and different stocks will have different standard deviations no matter what their price is. The size of the movement that a stock undergoes will determine the standard deviation. If a stock regularly makes larger moves, then it will have a larger standard deviation.
We can use standard deviation to assign probabilities of where a stock will close every day. When these occurrences, or stock closing prices, are plotted on a graph, they create a normal distribution or bell shaped curve.
What this curve tells us is that 68% of the time a stock will close within 1-standard deviation of its average price. This makes sense since most stocks don't make large unpredictable moves. Most of the time a stock will move about the same each day, little by little.
When we use the bell curve to look to 2-standard deviations out, we can see that a stock's closing price will fall within that range 95% of the time. Looking out to 3-standard deviations we can see that a stock's closing price will fall within that range 99.7% of the time.
Set your Bollinger bands to track 2-standard deviations around the 20-day moving average. Rarely does a stock move outside of 2-standard deviations, and when it does, it will quickly come back within the bands. If 2-standard deviations track 95% of the stock’s movement, that means a move outside of the bands only happens 5% of the time.
If you are an option seller, you may want to focus on strike prices outside of 2-standard deviations. This will give you a higher probability of success. Or, if you are looking to buy a reversal you may wait until the stock moves outside of the Bollinger bands before purchasing a call or put option.
The last indicator we use is Stochastics. The Stochastic Oscillator is a momentum indicator that will tell us when a stock is overbought or oversold. Stochastics will derive its reading from the speed at which the price action moves.
Stochastics will give you a reading between 0 and 100. When Stochastics reads between 0 and 20 your stock is oversold. Oversold means the stock has sold off too fast or for too long and it needs a break. When you have a reading between 80 and 100 your stock is overbought. When a stock runs up too fast or for too long it becomes overbought.
When a stock becomes overbought or oversold it needs to rest before moving higher. A stock can rest two different ways: time or price. When a stock rests through time it needs a couple of days of moving sideways before it can continue on its path. A stock can also reverse its price action to work off the overbought or oversold condition.
Whatever set of indicators you use, you want to make sure you can still see the chart. Too many traders fill up their charts with so many lines and indicators that you can no longer see the price and volume. Keep your charts clean so you can focus on the information that truly matters. Add indicators that are going to enhance your information, not cover it up. Only add the ones that will matter to your trading and keep all the others off your chart. Keep your focus on price and volume.
Technical analysis may seem like more of an art than a science, but it is a great resource for short-term trades.
Human tendencies don’t change, and we can track these tendencies in the charts that we read. By understanding greed and fear and how a trader processes this information, we can make our own decisions on trades.
Support and resistance lines are formed in areas with high levels of price activity. A resistance will have a higher number of sellers versus buyers, and a support zone will have a higher number of buyers. Once these orders dry up we will see breakouts and breakdowns.
These are the areas we want to focus on when deciding what types of trades to use.
How do you use technical analysis in your trading? Let us know in the comments...