TRADING OPTIONS
Separating The Winners From The Losers
Synthetic Swing Trading
by Carley Garner
Trading successfully means being aware of support & resistance levels. Here are some examples to help you understand the world of option trading.Because markets tend to trade in a defined range, outright long option positions are priced to lose. In fact, typically, most options that are more than two strike prices out-of-the-money, in the direction opposite of the overall trend, and with fewer than 45 days until expiration, expire worthless. As a result, constant awareness of support and resistance levels is crucial.
With that, let's look at the trade we took advantage of in January 2006. This is one example of a trading strategy we have implemented countless times, usually with similar results. The time, strike prices, and underlying futures contract month may differ, but the approach and strategy never do.
First of all, the March 2006 Dow contract saw a major runup in November and December 2005. We formed the basis for our trade by keeping in mind that the stock market tends to make a run higher from November through March every year, but also that markets often digest big moves.
The initial runup extended from December 2005 through January 2006. Knowing what goes up must eventually come down, we waited for a signal that the run had come to an end and a selloff would begin.
Our favorite trend reversal signal is produced by a combination of a crossover of the three- and seven-day simple moving averages, and a confirmation of the trend given by the 8/20 moving average convergence/divergence (MACD) with a 9 trigger. Because of the implied volatility factor of an option, however, we tend to make our move before the actual signal is produced. This is to get a jump on the potential premium explosion on the puts and erosion on the short call. The timing of our entrance isn't as crucial as it would be using a futures contract because of the lower delta values of options relative to futures.
Figure 1 shows that the market found resistance just below Dow 11100. The seasonal indicator at the bottom of the chart shows that the market is normally bearish going into mid-January. (The seasonal trend indicator displayed observes the relative position of the market versus its contract high and low.) We used a Fibonacci scale to determine how far the market could fall. In this case, we would expect the market to find support at either the 50% (10692) or 61.8% (10598) level on the scale. Based on a combination of standard technical and fundamental analysis, we could have been able to see the market decline to somewhere between these two levels.
...Continued in the October issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the October 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
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