You are on page 1of 58

Technical Analysis for

Options Trading
Disclaimer
The views and opinions expressed in this presentation reflect those of the individual authors/presenters
only and do not represent in any way Bourse de Montréal Inc.’s (the “Bourse”) opinion or any of its
affiliates. The presentation is not endorsed by the Bourse or its affiliates. The information provided in this
presentation, including financial and economic data, quotes and any analysis or interpretation thereof, is
provided solely on an information basis and shall not be interpreted in any jurisdiction as an advice or a
recommendation with respect to the purchase or sale of any derivative instrument, underlying security or
any other financial instrument or as a legal, accounting, tax, financial or investment advice. The Bourse
and its affiliates do not endorse or recommend any securities referenced in this presentation. The Bourse
recommends that you consult your own advisors in accordance with your needs. Although care has been
taken in the preparation of these articles, the Bourse and/or its affiliates do not guarantee the
completeness of the information contained in this presentation, and are not responsible for any errors or
omissions in or your use of, or reliance on, the information. The Bourse reserves the right to amend,
review or delete, at any time and without prior notice, the content of this presentation. The Bourse, its
affiliates, directors, officers, employees and agents will not be liable for damages, losses or costs incurred
as a result of the use of any information appearing in this presentation.

“S&P ®” and “Standard & Poor’s ®” are registered trademarks of The McGraw-Hill Companies, Inc. and
“TSX” is a trademark of TSX Inc. (“TSX”). The products mentioned in this presentation are not sponsored,
endorsed, sold or promoted by S&P or TSX; and S&P and TSX make no representation, warranty or
condition regarding the advisability of investing in them.
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:


ƒ Financial Statements
ƒ Management and Competitive Advantages
ƒ Competitors and the Industry Potential

• This does not account for the nature of free


trading markets.
Technical Analysis

• Markets are “marked to market.” All stocks 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:
ƒ Identify trends.
ƒ Identify support and resistance levels.
Technical Analysis & Options

• As the option buyer:

ƒ Establish a directional bias by identifying a trend.


ƒ Determine a strategic entry point for an option purchase.
ƒ Establish targets and exits for trade management.
ƒ Strike price selection.
ƒ Strike price selection for debit spreads.
ƒ Put/call selection for protection on long/short stock
postions.
Technical Analysis & Options

• As the option writer:

ƒ Establish a directional bias by identifying a trend.


ƒ Use Support & Resistance for uncovered writing.
ƒ Strike price selection for covered call writing.
ƒ Strike price selection for credit spreads.
ƒ 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

CANDLE
Positive Candle & Bar

High High
Close Close

Open Open

Low Low
Negative Candle & Bar

High High

Open Open

Close Close

Low 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:

ƒ An up trend will make higher highs and higher lows


ƒ A down trend will make lower highs and lower lows
ƒ 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.

ƒ Range of price movement (volatility).


ƒ Time that it takes for the price to move.
ƒ 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
ƒ Measured by the securities deviation from its
average price.

• Implied Volatility
ƒ 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
Sep Dec
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
+/- $10.00 potential B/E =73.32

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
Break Option value
Option Contract Cost Net Profit
Even at expiration

January, 74 strike put $0.68 $73.32 $0.00 -$0.68 loss

+$5.94
January, 82 strike put $2.70 $79.30 $8.64 (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:


ƒ Stocks that are trending higher for covered call writing.
ƒ Resistance levels for writing calls that are likely to expire.
ƒ Support levels for writing puts that are likely to expire.
ƒ 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 BUY CALL = $0.52

expiration. $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.

You might also like