Technical Analysis for Options Trading
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Agenda • What is technical analysis. • Options and their relation to stock prices. • Technical analysis and the option buyer. • Technical analysis and the option writer.
Fundamental Analysis • Fundamental analysis is the study of the comparative valuation of a company. • This involves the review of:
Financial Statements Management and Competitive Advantages Competitors and the Industry Potential
• This does not account for the nature of free trading markets.
Technical Analysis • Markets Markets are “marke “marked d to market market.” .” All stock stocks s are valued based on the last price. • Pure form of supply and demand and little to do with the fundamentals of a company over any short term period. • Technical Analysis is the process of trying to interpret that supply and demand.
Price action discounts everything • Share prices adjust to new publically available information including M&A and earnings announcements. • This supports the idea that all known information is priced into the markets as share values adjust to reflect the new valuations. • That supply and demand sequence is mapped using price charts.
Technical Analysis • There is no holy grail trading technique. • Technical analysis is a tool to be used in combination with sound risk management principles. • Objective:
Identify trends. Identify support and resistance levels.
Technical Analysis & Options • As the option buyer:
Establish a directional bias by identifying a trend. Determine a strategic entry point for an option purchase. Establish targets and exits for trade management. Strike price selection. Strike price selection for debit spreads. Put/call selection for protection on long/short stock postions.
Technical Analysis & Options • As the option writer:
Establish a directional bias by identifying a trend. Use Support & Resistance for uncovered writing. Strike price selection for covered call writing. Strike price selection for credit spreads. Strike selection for put writes with the objective of owning the stock.
Principles of Technical Analysis
What is a price chart? • The open/close, high/low of a stocks price is plotted based on a specific time frame. • There are different types of price charts, most popular are bar charts, candle charts or line charts. • How each price/time measurement plots beside one another determines the trend. • Can use different time frames depending on objectives
Typical Candle, Bar & Line charts LINE BAR CANDL
Positive Candle & Bar High
High Close
Close
Open
Open Low
Low
Negative Candle & Bar High
High
Open
Open
Close
Low
Close
Low
What is a Trend? • Simply the direction that the market is going. • Market never moves in a straight line. • Direction of peaks and troughs. • “Up”, “down” or “sideways” trends.
Trend Identification • Simple rules of thumb:
An up trend will make higher highs and higher lows A down trend will make lower highs and lower lows Use peaks and troughs to draw a trend line
Up Trend Identification
Down Trend Identification
Support and Resistance • Strength/weakness at certain price levels. • Lows are considered support. • Highs are considered resistance.
Prices Testing Support
Prices Testing Resistance
Options Pricing and The Underlying Security
Option Pricing Variables •
Underlying Price
•
Strike Price
•
Time
•
Interest Rates
•
Dividends
•
Volatility
Option Pricing Variables • Out of the 6 pricing variables of an option premium, 3 of them can be observed through a simple price chart analysis.
Range of price movement (volatility). Time that it takes for the price to move. Stock price and its relationship to the strike price (intrinsic value).
Option Pricing Variables • Investors can visualize the personality of a stock. • This helps to better determine which strategy, option strike and expiration will best suite the current market environment.
Volatily, Historical vs. Implied • Historical Volatility
Measured by the securities deviation from its average price.
• Implied Volatility
markets expectation for future volatility.
Low Volatility and Option Pricing1 • Stocks with a low historic volatility typically will have less expensive option premiums. • This trading behavior can be identified in the price/time relation in a chart. • Consideration must be given to allocating the appropriate amount of time when selecting an option expiration date and strike price.
BMO - Low Volatility Dec 13, 2010 30 Day Historic Volatility = 16%
January, 64 strike call = $0.50
$8.00
3 MONTHS
Sep
Dec
High Volatility and Option Pricing • Stocks with a high historic volatility typically will have more expensive option premiums. • This trading behavior can be identified in the price/time relation in a chart. • These stocks are better for trading a short term directional view using options. • May be better debit spread candidates as well.
RIM - High Volatility
Dec 13, 2010
30 Day Historic Volatility = 30% January, 64 strike call = $2.65
$20.00
3 MONTHS
Time and Probability • Because options are time sensitive it is important to visualize price potential over a specific time frame. • Price charts can be used to identify a trade range over a certain period. • This can be powerful for strategy selection as well as option contract selection.
Agrium ( AGU) Dec 13, 2010 Purchase 1 January, 74 strike put = $0.68
74 B/E =73.32
+/- $10.00 potential
Sep
Dec
Jan 14
Agrium ( AGU) Dec 13, 2010 Purchase 1 January, 82 strike put = $2.70
82
B/E =79.30 +/- $10.00 potential
Sep
Dec
Jan 14
Strike Price Comparison AGU starting price = $83.36 AGU price at expiration = $73.36 Option Contract
Cost
Break Even
January, 74 strike put
$0.68
$73.32
January, 82 strike put
$2.70
$79.30
Option value at expiration
Net Profit
$0.00
-$0.68 loss
$8.64
+$5.94 (220% return on risk)
Technical Analysis and The Option Buyer
Timing a Long Option Purchase • Market timing is an important consideration. • An investor can be fundamentally correct, but not have allocated enough time for the options to profit. • Longer term options are expensive and can mitigate much of the benefit for being fundamentally correct.
Timing a Long Option Purchase • Technical Analysis offers definitive signals for entry and exit. • Since technical analysis is typically used for market timing, option buying and technical analysis compliment one another.
Timing a Long Call Purchase Bank of Nova Scotia - BNS
DECEMBER 3 - BUY CALL
RESISTANCE/SUPPORT
Sep
Dec
Timing a Long Put Purchase Research in Motion - RIM
SUPPORT
MAY 20 - BUY PUT
May
July
Price Target Objectives • Key principle in actively trading any market is locking in profits. • Establishing price targets on a chart helps the option trader set objectives, creating a visual reference. • Think of a price chart as a “road map” for managing an option trade.
Price Target Objectives • A common mistake is having an inflated expectation of profit on an option position. • In many cases, a novice option trader will hold a position into a support or resistance level, ignoring the potential for reversal because they expected the option to be “worth more”. • Remember…the option contract will only be worth what the market is prepared to pay.
Call Option Target Objectives Research in Motion - RIM
TARGET 3
TARGET 2
TARGET 1
NOVEMBER 25 - BUY CALL
Sep
Dec
Put Option Target Objectives Thompson Reuters Corporation- TRI
NOV 29 - BUY PUT
TARGET 1
TARGET 2
TARGET 3
Sep
Dec
Bull Call Spread Strike Selection Thompson Reuters Corporation- TRI Sep 2, 2010 - Purchase 1 November, 38 strike call = $1.40 Sell 1 November, 40 strike call = $0.50 Net cost = $0.90 RESISTANCE SELL CALL
$2.00 SEP 2 - BUY CALL
July
Sep
Nov
Bear Put Spread Strike Selection Agrium - AGU November 3, 2010 - Purchase 1 January, 86 strike put = $5.50 Sell 1 January, 80 strike put = $2.60 Net cost = $2.90
NOV 3 - BUY PUT
$6.00 SELL PUT SUPPORT
Nov
Jan
Timing a Protective Purchase • The challenge for many investors is when to implement a protective option strategy. • Use price charts to identify a potential change in a trend. • Use support and resistance levels to identify which strike price would be most effective.
Long Stock , Buy Put for Protection Shoppers Drug Mart - SC November 1 - Buy/own 100 shares @ $40.00 Purchase 1 December, 38 strike put = $0.65
SUPPORT BUY PUT
SUPPORT
Oct
Dec
Short Stock , Buy Call for Protection Research In Motion- RIM Nov 1 - Short 100 shares @ $58.00 Purchase 1 Dec, 60 strike call = $2.20 NOV 1 – BUY CALL RESISTANCE
Nov
Jan
Technical Analysis and The Option Writer
Objectives of the Option Writer • Identify stocks appropriate for covered call writing. • Sell options with a high probability of expiring worthless to generate cash flow. • Create Credit Spreads to limit margin requirement and indentify risk while generating cash flow. • Sell put options to generate cash flow while waiting to own the stock at a more favorable price.
The Role of Technical Analysis • “ A Picture is worth a thousand words”. • Analyzing a chart can help the option writer identify:
Stocks that are trending higher for covered call writing. Resistance levels for writing calls that are likely to expire. Support levels for writing puts that are likely to expire. Support levels for writing puts to ultimately trigger the purchase of the underlying shares.
The Covered Call Writer Encana- ECA December 29 - Buy 100 shares of the stock @ $29.00 Sell 1, February call
OUT OF THE MONEY - $0.65
AT THE MONEY - $1.10
SUPPORT
Oct
Dec
The Uncovered Call Writer Nexen- NXY Nov 15
Jan SELL UNCOVERED CALL = $0.65 RESISTANCE
DECEMBER 18 - OPTIONS EXPIRE
November 15 - Sell uncovered, December, 23 strike calls where resistance is anticipated.
The Uncovered Put Writer Tim Hortons - THI October 15 - Sell uncovered, November, 37 strike puts below key support. NOV 19 – PUTS EXPIRE
SUPPORT SELL UNCOVERED PUT = $0.36
Oct 15
Jan
Credit Spreads Goldcorp- G December 29, Bear Call and Bull Put Credit Spreads, February expiration.
BUY CALL = $0.52
$0.40 credit SELL CALL = $0.92 RESISTANCE
SUPPORT SELL PUT = $0.60
$0.26 credit BUY PUT = $0.34
Dec
Put Writing for Share Purchase Encana- ECA November 22 - Sell uncovered, December, 28 strike puts. Collect $0.65. Own shares on expiration if trading below $28.00.
DECEMBER 17: OPTIONS EXPIRE
SUPPORT SELL UNCOVERED PUT = $0.65
Nov 22
Jan
Conclusions • Technical Analysis should be used as a tool to compliment a sound investment and trading plan. • Use a price chart to time option purchases more effectively by identifying the continuation or reversal of a trend. • Identify support and resistance levels for establishing targets. • Identify support and resistance levels for option writing opportunities.
