Best Technical Analysis Methods for Options Trading
Unlike traditional assets, options offer traders the flexibility that comes with different calls, puts, strike prices and expiration dates; not to mention the ability to create hundreds of different types of spreads and combinations to take advantage of different types of market conditions, volatility disparity as well as seasonal tendencies.
Most options traders anticipate three different types of price movements, I decided to separate and categorize the most common types of movements and then select the best technical analysis method to take advantage of that type of price movement, taking into consideration that you are trading options instead of the underlying asset.
Here are the three different possibilities:
1. Strong directional movement
One of the best technical analysis methods for finding candidates that are moving rapidly is the 20 day exponential moving average. The exponential moving average is more responsive than the traditional moving average and places more weight on more recent price data, therefore it makes a great choice to help you gauge the strength of the trend.
Another great technical filter that I like to use is 90 day price highs. According to numerous back tests, assets that make 90 day price highs, tend to continue moving in the same direction and increase momentum levels. Many traders believe that stocks as well as other assets are priced too high when trading above 90 day price highs, but if you take a look at major price breakouts that continue for months on end, they all start out with breaking the 90 day price high.
NOTE: The percentage of false breakouts is also lowest near the 90 day level and increases if you move to a substantially lower or higher time period as well.
2. Mild Directional Movement
The second type of price movement is a mild directional movement, which usually results from a bounce, pullback or a continuation in momentum after a pause. You will find that these types of movements usually occur while a trend is already on the way and the market is pausing and re-balancing before once again continuing to move in the direction of the main trend.
One very simple and effective method of identifying mild directional movements that work well with options, is to identify assets that are pulling back while in a strong uptrend. One indicator that works well for this type of analysis is the RSI indicator. I typically adjust the time period from 14 days to 10 days because my time frame is shorter; but otherwise there are no other changes that need to be made to the indicator.
While there are other oscillators that are similar to the RSI indicator, I find that the majority of these oscillators are too sensitive to price data and generate too many false signals. Therefore, I avoid the stochastic, MACD and other momentum oscillators and almost exclusively rely on the RSI for overbought and oversold analysis.
NOTE: Mild directional movement is ideal for options spreads and other combination strategies. On the other hand, if you are trading net long or short positions and want maximum directional movement, you may want to use momentum strategies that are identified in section 1.
3. No directional movement
Often times options traders, especially premium sellers want nothing more than very little to no directional movement and want to take advantage of premium decay. Similarly, when option writers sell premium, they also want a higher level of volatility, which increases the amount of premium that the options writer brings in, due to a sharp increase of implied volatility that expands when volatility increases.
One of the best methods of identifying a range bound market that has substantial range expansion is to utilize the Bollinger Band indicator.
You can see in this example, how the Bollinger Bands maintain several months of price action on the SP 500 within the upper and lower band. Notice the envelope expands and contracts as volatility or trading range moves higher and then lower, this is a good way to determine if volatility is increasing or decreasing.
If the Bollinger Band envelope is expanding, then volatility is increasing and if the Bollinger Bands are becoming narrower, then market is becoming more range bound and volatility is decreasing. Many professional traders sell options when the bands are widening and buy the options back when the bands are becoming narrower.
Another way many traders utilize Bollinger Bands, is to use the bands as support and resistance levels; to sell premiums outside of the upper and lower bands of the envelope, since these levels offer fairly conservative trading levels for both the upside and the downside.
In summary, there are different technical analysis indicators and trading patterns and each one works best in different market conditions. The type of indicator and/or analysis method you choose should take into account the type of price move you are anticipating, the options strategy you plan on utilizing and the level of volatility in the underlying asset at the current time.