Technical Analysis For the Advanced Options Trader
Technical analysis often plays a large part in the determination to enter or exit stock trades in the short and intermediate term. It can also play a part in determining entry and exit of long option trades (buying calls or puts). What about using technical analysis in determining entries and exits of more complex options strategies such as vertical spreads, calendar spreads, iron condors and diagonal spreads? In this article, I want to specifically address the use of technical analysis in advanced options trading.
The problem with technical analysis
Even the best market technicians can only tell you what is likely to happen. This isn’t the fault of technical analysis (TA for short) or in the practitioners of it. It is simply a fact that must be reckoned with. TA is much more like checking the direction of the wind than a predictor of which way it will blow tomorrow.
While TA may be able to tell you what is likely to occur or what is going on at the moment, it can’t tell you your probability of success in a trade. There has been some work to quantify the accuracy of different technical indicators, particularly in the area of chart patterns, but that still doesn’t help with the analysis of the trade itself.
One other danger of technical analysis is the temptation to pile on a bunch of indicators in the hope that it will somehow give us additional insight or edge in trading. I’m not saying the employment of stochastics, MACD, Bollinger bands and the like aren’t important but their use in the overall trading strategy must be understood.
Technical analysis must also be correlated to a timeframe to be effective. In other words, you must know the timeframe you are working in. Is it short term (days), very short term (intra-day), medium term (weeks) or long term (months). To be effective, you must understand the timeframes involved in the options trade and ensure that technical analysis is done for the same timeframes.
Don’t get me wrong, I’m not against using TA for advanced options trading. In fact I’m a firm believer and practitioner of it. However, it is important to realize the limitations as well the benefits and uses. In fact, let’s take a look at some of the benefits.
The benefits of technical analysis
Technical analysis can be used to time an entry or trigger an exit. I often use basic support and resistance levels to do just that. In fact, I believe the combination of TA to time an entry combined with probability analysis for choosing my position actually improves my overall success. Also, when I have a clear support or resistance level that can be used as an indicator that my initial analysis was wrong, I often exit a trade earlier keeping more of my money for another trade.
One other area of TA I find beneficial is in determining overall market outlook. Remembering that timeframe is important, I often use TA to determine what the medium term trend is. This can help me determine what kinds of trade strategies to best employ over the coming weeks.
I’m sure there are other very successful options traders who have found additional uses for TA. In fact, I’m sure there are as many ways to incorporate technical analysis as there are strategies to use them on. That’s what makes trading so interesting. In fact, networking with other successful traders can be an important factor in determining your own trading style.
Knowing how and when to use technical analysis
Ultimately, the determination of how and when to use technical analysis is up to the trader and the trading plan(s) they are using. Understanding the limitations as well as the benefits of technical analysis is a great start. From there, experiment with different approaches using some form of paper trading until a clear strategy emerges.
It’s best to start with basic support and resistance analysis. Keep it simple. Use only the indicators that you are comfortable with and that help in making basic trading decisions. Ultimately though, you as a trader must make that decision to enter or exit the trade based on your evaluation of all the factors.
Putting it all together
In concluding this article, I wanted to provide 4 key tips in using technical analysis for advanced options trading.
Determine what technical analysis tools will be used. It’s easy to be distracted by all the indicators that exist. Paper trade and experiment but start simple. Support and resistance should be your first and primary indicators. Everything else should simply be confirming indicators. Don’t have so many indicators that they drive you to indecision.
Determine timeframes you will use for your technical analysis. Make sure the TA tools used are consistent with the timeframe you are trading. Most advanced options strategies last weeks to months. Make sure the timeframe analyzed is the same.
Put your strategy for technical analysis in your trading plan. Once you decide how and when to use TA, make sure that it becomes part of your trading plan for each strategy employed by writing it in. Having a written trading plan you can look at frequently is a great help to being consistent with that strategy and consistently using TA according to your plan.
Stay flexible. Remember TA isn’t an exact science but more of an art. As you practice, you’ll get better. Remember also that the outlook at one point in time can change in a matter of days. Be prepared to change your outlook if the technical indicators warrant it. However, don’t let small changes drive you to flip-flop in your trades. Continue to take trades for sound reasons and exit for sound reasons.
There is a lot of great information on technical analysis out there. I’ve summarized some of the basic techniques on the TA page of my website at http://www.success-with-options.com/technical-analysis.html. In addition covering how I use TA in my trading there, I’ve included references to some great sites. Be sure to check it out.
Remember to investigate, plan, experiment (with paper trading) and implement technical analysis into your options trading strategies. It can seem like a slow process of getting there but the confidence and consistency you achieve in your trading will be well worth it.