Monthly Archives: December 2014

Spotting Big Trends With Technical Analysis

Trading Rule #1: Trade with the trend.

Trading Rule #2: Buy Low – Sell High: or Sell High Buy Low.

Trading Rule #3: Understand and stick to a disciplined trend and trading time-frames.

If it was only that easy…

Big Trends in the market are easy to spot, the most recent obvious trends are in everything Oil. Down, down, down. Look closely at rule #3… Because trends and time-frame are where traders make mistakes. When thinking about a trade consider both the TREND time-frame AND your TRADING time-frame.  In this case we’ll call the TREND time-frame, The Major Trend and we’ll consider entering trades on Minor Trends (Rule #2).

CL-1Mo

The Major Trend to trade in Oil is clearly short. To keep this simple, we should enter short trades on our trading time-frame as close as possible to the red line.

The S&P provides a different type of example because the Major trend is ‘longer’. The S&P is not trending as clearly as oil on a monthly chart.

ES-1MoTo see the S&P trend we have to move the trending time-frame to a yearly chart, (the monthly chart looks like it’s found a range).  I’ve left the MACD and a stochastic on the yearly chart to drive a point.

es-tvEach time over the last few years the S&P has approached the 50 day moving average we’ve bounced and continued the Major Trend. If you are looking at the S&P and trying to call the top of this trend, count on losing money. You might be right, it can’t go on forever, but the Major Trend on the S&P is up. Trading short, at this point is too risky. Traders are making money buying the dips on the S&P and shorting the spikes on Oil. You’ll get faked out here if you try to call the top on the S&P or the bottom on Oil.

Lets have a look at Starbucks, first the Major trend, up… The moving averages have been supporting SBUX for a few years. 75 (moving average) and 66 (support/resistance) are trend reversal levels.

sbuxAnd the minor trend, our trading time-frame, also up:

sbux-1MoBut this chart is flashing a few technical warnings. First, the 3rd flag we’re seeing is not as “clean” as the first two and volatility (high-low ranges) is higher than during the two earlier flag setups. I’d say that we’re seeing the TOP of this trading (minor) trend. Why? Traders are less bullish and the resistance line at 84 is firmer (there are lots of stop-losses around 84). You can confirm this with the option chains.

I would suggest if you’re going to trade the trend on SBUX you use one of two strategies: A breakout strategy or a trend resistance level strategy. What I mean by the breakout strategy is that if SBUX breaks into a short-squeeze (over 84) get in for a short trade, and ride up the short squeeze, but that’s a major possible fake-out. It’s a hard trade, but easy money. Don’t stay in long! The short squeeze will happen within the next 5 days, if it happens. Notice the duration of the other 2 flags…

If SBUX doesn’t get squeezed, be patient, watch how this chart plays out, Look for entries at the trend levels 80/75, and eventually 66 before going long. Under 66 the major trend will have reversed.

I won’t say a word about trading against the trend… Or I’d have to break rule #1!

 

Option Chains, Indicators, and Insiders

Trading options is appealing for several reasons: leverage, spreads, and pricing is based on a ‘model’. Each of these reasons appeal more or less to traders who use options as part of their trading strategy.

Lets take leverage, the most obvious, for only $150 I can ‘trade’ an 80 Dec call option on SBUX (Starbucks). The nominal value of that option contract is ~$8000.  (I’m assuming you understand the basics of option pricing.) Multiply that by 10 and for $1500, you can trade 80k of SBUX stock. Who wouldn’t like options? (That’s the trap, on too spreads…)

Good spread trading allows you to stay in business a bit longer – bad spread trading puts you out of business quicker.  I can create spreads or ‘construct’ combinations of put, calls (and futures) which fit a particular strategy. For example, if I think SBUX is going stay flat for a while, I’d like to create a spread, selling options outside my projected range.

There are a few models, the most common is Black Scholes. These models appeal because they give traders a structure and theoretical pricing. They help you determine if a particular option is over-priced or under-priced. From this perspective they act as an indicator. Experienced traders will pay significant attention to models and pricing. For good reason. Statistically the ‘premium’ you pay for an option is based on the likelihood that it will expire worthless. Many traders will tell you that the only way to make money with options is on the sell-side. In other words, the pricing model, is better at predicting future prices than they are. That’s hard to argue with.

Lets take our Starbucks example and look at it’s option chain – I’m going to avoid the weekly options, they were designed to tempt the retail trader into losing their shirt. We’re also going to see if we should use options as part of a strategy with SBUX.

sbux-option-chainSo what should we be looking for here?

The first thing to look at is OI (open interest). SBUX OI is saying the 80 strike is the most active, but 6 or 7 times more active than the put side – that’s bullish. Does that correspond to our strategy? No, we’re assuming SBUX is going to stay flat. Though if we look at the IV (Implied Vol), calls are relatively cheap. If you want to continue to dig into ‘relatively cheap’, work on the model, and have a look at HV (Historic Vol).

The second thing is volume/price spread. There are NO institutional bets ‘out of the money’ on SBUX. Volume is low. Often you’ll see big trades being made around earnings, and those are good indicators. SBUX is NOT showing any big out of the money bets. Price spread is bid-ask difference – low volume leads to large spreads which implies bad pricing (remember our model?). I’m oversimplifying, but if you don’t know what you’re doing, STAY AWAY from low volume, high price-spread, low open interest options!

Back to the problem, should we use options to fit our strategy of ‘flat’? I’ve highlighted a proposed range ~80-82.

sbux-daily-1mo

Technically this is a very bullish chart with two bull flags, hence the high call open interest. If we’re flat we’re predicting that we’ve jumped to the next range. Is ‘flat’ still a good strategy? December expiration is the only contract period we might sell calls or puts outside our range and even in December our Condor strategy is very limited with almost no open interest at 79 and 84. If you’re flat SBUX, the option chains are screaming, stay away from me.

Should we adjust our strategy? Is the bullish open interest enough for us to change strategies or start looking for another? That’s a personal call, but lets say it’s time to go full bull. 6-7 times Open Interest on the Call side is a strong indicator. Not as strong as an institutional trade, but strong none-the-less. What’s the trade? Buy the 80 expiration sell the 82.50 expiration. That trade will make money if the SBUX December contract closes over 81.  We’re still theoretically in our range so I’d take that spread one step farther and look at a calendar (diagonal) spread, selling the Jan 82.50 and buying the Dec 80.

What’s the P&L look like on this trade? Break even is ~ 81.25, you’ll have to get out or adjust around Dec. expiration… The probability curve based is in blue and the P&L is based on 10 contracts.

p&l-sbux-cal

How can I learn more about option chain indicators? My favorite tool is livevol pro. If you can’t afford that, watch option chains with high activity. Most trading platforms will give you scanners that find: high open interest, high call/put activity and high/low vol filters. Option chains can be great indicators for stocks you trade, Starbucks in this example. They can also be used as a tool for finding new stocks to trade.