CHAPTER
14

Technical Analysis

In This Chapter

• Understanding technical analysis
• Looking for basic patterns
• Why it’s believed to work
• Using technical analysis in trading

Technical analysis involves looking at the trading history of an underlying asset or a derivative to find trends that might indicate future prices. It often seems like reading tea leaves, but prices contain information about the conviction behind changes in supply and demand. Certain reactions to changes in the outlook of the underlying asset often play out in more or less predictable patterns. Some of these patterns are driven by rational behavior, while some are driven by raw emotion. Either way, these patterns affect prices.

The more conviction, the more information and the more likely a trend is to continue. That’s the short answer.

Day trading, especially with common stock, relies heavily on technical analysis. Many day traders work from the charts, with little or no regard for other dynamics influencing prices. Many options traders also work from charts, because most traders close out their positions before expiration. Some find technical analysis to be useful for finding entry and exit points.

Technical analysis is used in other markets, too. It’s helpful to have a passing familiarity with some of the major terms and major indicators that you might run across as an options trader. Understanding these indicators both help you see how they affect your own trading, as well as how they affect expectations.

The Basics of Technical Analysis

Technical analysis starts with charts of the performance of an investment. It shows the range of prices over a given time period (usually a day). The charts are designed to show the high, low, and closing prices.

Let’s work through an example from a financial website, finance.yahoo.com, using shares of Facebook, which trades under ticker symbol FB.

This is what a bar looks like:

A bar is a straight line showing the range of prices during the trading period. The high for the period is at the top, and the low is at the bottom. Some platforms show the line in red if the price fell over the period and in green if it rose.

Often, the chart will have two parts: a series of bars in the top part and a bottom part showing the volume of contracts or shares. Not every time of underlying asset has a viable volume number (a market index, for example). If a chart includes volume data, though, you can use it to see how much activity is driving changes in price.

A chart with bars and volume looks like this:

This is a price chart showing a range of bars over a given time period. It might show hourly bars over the course of a day, daily bars over the course of a month, or even annual bars over the course of decades.

These charts are generated automatically by almost every website and brokerage firm that tracks investment prices. They are easy to find and generate. The information shown in these charts is easy to use, too. Without spending too much time or effort, you can see:

• How much the price has changed over time
• Whether that price change has been a smooth ride or really volatile
• How much trading takes place on a typical day
• Whether trading volume changed on days with big price changes

Then, you can overlay the performance of a different market benchmark (discussed in Chapter 19) to show how the price of the underlying asset varies with the price of other market factors. Using this strategy helps you see if the price is moving with the market or against it.

This chart shows the performance of a benchmark index (A) set over a price chart showing an overall market index (B). The benchmark is usually drawn at its closing price for the period.

You’ve already done some basic technical analysis! Wasn’t that easy?

Trendlines

A trendline is nothing more than a line drawn on a chart, Simple straight lines are shown running through the series of price bars. The following chart shows an example.

A trendline is simply a line drawn to smooth out the bar chart and show the overall direction of the asset’s price.

Trendlines clarify the direction of a trend over different time periods. Some trends play out in a few days over the course of a long-term trend that is moving in a different direction. If the time to expiration of your option position is far out, then long-term trends in the underlying price matter more to you than do short-term deviations from trend.

In addition to the basic trendlines, you’ll want to look at support and resistance lines. They look like this:

The support line shows the lowest price at which the asset trades in a given trend. The resistance line shows the highest price.

The lines form a channel, with the top line being the maximum price level in the trend, and the bottom line being the minimum price within the trend. This sort of chart is sometimes called the supply zone, because as the price of the underlying asset approaches that price, a growing number of sellers are willing to short. That maximum is the level at which prices resist going much higher. The minimum—or support—level is the price at which lower prices seem to stop. The support level is also known as the demand zone, because at that price, traders are willing to go long the underlying asset.

Traders will buy at the support level, looking at the low line on the channel. The idea is that here, the underlying asset is unlikely to go lower in price, so you’ll get the best purchase price here. Then, the trader will watch the price. When it hits the resistance level—top line—the trader will sell because the price is unlikely to go higher.

An option trader might look at the support and resistance levels to manage risk. For example, if you are writing puts, you would want the strike price to be below the support level in order to minimize the risk of the option being exercised. A trader writing calls might want to set the strike above the resistance level.

Of course, trends change, which brings us to the next point.

More precisely, it brings us to the pivot point, which is the formal determination of support and resistance levels. A pivot point is the average of the high, low, and close for the day. If the next day’s price closes below the pivot point, then the underlying asset has a new support level. If it closes above the pivot point, then there is a new resistance level.

As long as the trend holds, the underlying asset will be relatively expensive when it hits the resistance level and relatively cheap when it hits the resistance line.

Moving averages are useful in and of themselves, but they are also components of other trading indicators:

A crossover occurs if the price crosses the moving average line. A crossover above the moving average would indicate the price trend is upward. This means it might be a good time to buy calls or short puts. For example, if the crossover occurred at a price of $30, you could establish a long call position with a strike of $31. Then, you could exercise it if the crossover indicator was correct and then started trading at an even higher price. Or, you could write covered calls with a strike price of $29, under the assumption the indicator held, you would receive the premium, and the option would expire worthless because the underlying asset increased in price. If the crossover cuts below the moving average, then a long put with a strike price below the moving average is more likely to become in-the-money, and a short call with a strike price above the moving average is more likely to expire worthless.

A convergence takes place when moving averages calculated over different time periods come together. This is often a sign a trend is ending.

If the moving averages for different periods move apart, then a divergence has occurred. This usually means a new trend is beginning.

Breakouts

Trends don’t hold forever, though. If it changes, then you’ll see a channel looks something like this:

When a price bar crosses the trendline, a breakout has taken place. It signals the start of a new trend.

The breakout is the point where the price crosses the trendlines to form a new trend. This new trend has its own support and resistance level.

If a new trend does not start, then the technical analyst would call this a false breakout. Hey, technical analysis is not clairvoyance. Instead, it’s just one tool among many to help figure out what’s happening in the market.

Volatility

Volatility matters to the technical analysis of options for two reasons. The first is that volatility is a key component of an option’s price, so using charts as a way to find trends in volatility can improve your understanding of an option’s value. The second is that volatility within the options market is a key technical indicator used by investors and traders of all stripes as a way of gauging the sentiment of the market as a whole. If you’re trading options, pay attention! (Of course you’re trading options! That’s why you have this book, right?)

Vega, you might recall from Chapter 4, is how much an option’s price changes as the amount of volatility in the underlying asset changes. As the underlying becomes more volatile, the price of the option goes up, and vega tells you how much the price will increase.

A simple way to determine how the volatility implied in the option price compares to a typical level is to graph the implied volatility of the underlying asset and compare that to an historical moving average of actual volatility over a given time period—usually 10, 20, or 30 days. It’s hardly perfect, but it does give the trader a good first look at the situation.

By the way, vega doesn’t specify if the price of the underlying asset is more volatile on the upside or the downside, only the actual price is likely to vary from the expected price at any given point in time. An option can be volatile even if it goes up a lot in price.

Volatility Cones

A volatility cone is a graph showing the amount of realized volatility over different time horizons. The concept was developed by Galen Burghardt and Morton Lane, two futures analysts who published a paper about it in 1990. The cone itself is formed by a plot of the contribution of volatility to the option price as the option gets closer to expiration. In general, the intrinsic value of the underlying asset becomes less important to the price and volatility becomes more important as the option moves closer to expiration.

The chart looks like this:

The dot on the chart shows the current implied volatility of the option. The lines show the actual rolling average amount of volatility for the last 30, 60, 90, and 120 days.

The cone itself forms around the historic volatility levels and the implied volatility in the current price.

Volatility cones can be used to compare the amount of implied volatility in the current options price with the actual rolling average amount of volatility for the past 30, 60, 90, or 120 days. That gives you a clue as to whether or not the current option value is fair relative to its historic levels of volatility. If it’s underpriced, you buy; if it is overpriced, you write.

The VIX

The VIX, covered in Chapter 6, is an important measure of the volatility of the options market. Options traders use it to help indicate the market’s vega. It is also used as an indicator by people outside of the options market who want a measure of the amount of volatility expected over the next 30 days. After all, the VIX was an important technical indicator before it became a tradeable contract.

Reversals

A reversal is simply a change in trend to the opposite. They are obvious in hindsight, and many chart patterns show where they might happen again in the future.

Pennants and Flags

Pennants and flags are chart patterns showing a short-term deviation from the main trend. These patterns are nothing more than the shape formed by the support and resistance lines of a subtrend.

A flag has parallel lines:

A flag is formed if the support and resistance levels run in parallel.

A pennant has sloping lines, as shown here:

A pennant is formed if the support and resistance levels have different slopes.

Pennants and flags usually show up in the middle of a trend, stick around for two weeks, and then scram. If trading volume falls during this time, it is evidence of retracement; when it’s over, the main trend will continue. If it increases, you might have a reversal, which is a change in the main trend. A reversal is a good sign of the high or the low for the trend. Given the game is to buy low and sell high, a reversal is great to spot.

Head-and-Shoulders

The head-and-shoulders formation is a series of three peaks within a price chart. The one in the middle, known as the head, is greater than the ones to the left and the right (which are, of course, the shoulders). The line separating the head and shoulders from the rest of the chart is known as the neckline. The chart looks like this:

With a head-and-shoulders formation, the price bars arrange themselves into three peaks, with the higher one in the middle.

The specific reason for this pattern is traders are trying to eke out a few more profits at the end of a price trend. There isn’t enough demand to keep the trend going, though, and so the price falls.

And, of course, people who see a head-and-shoulders formation tend to respond as though a price decline is imminent, which makes it a bit of a self-fulfilling prophecy in the short term.

At the end of a downtrend, traders will start testing the lows, with the result appearing as a reverse head-and-shoulders:

A reverse head-and-shoulders formation has three valleys, with the deeper on in the middle.

A reverse head-and-shoulders formation is as bullish as a regular head-and-shoulders formation is bearish—in other words, very much so.

Cup-and-Handle

Assets fall in price all the time. At some point, the information gets out to all the traders in the market. They reassess the situation and, sometimes, decide it is time to buy again. This activity creates a formation that, if you squint, looks like a cup and its handle.

The cup-and-handle formation shows the price bars forming two high peaks, followed by a smaller peak.

The handle is formed by people who bought at the old high and who wait until the price recovers before they cash out. Once they’re out, the serious traders who understand the fundamentals will get in and ride the new uptrend.

For example, Idiot Enterprises stock reached a peak of $100 per share in January. Some not-so-smart stock traders decided this was a great time to buy shares because the price increase showed it was a great investment. (This is a really common mistake, by the way, because many traders wait for confirmation of a trend so long they end up buying high and selling low. Oops.) Then, the shares of Idiot Enterprises languish at about $95 for a while until it returns to $100, and the not-so-smart trader decides it’s time to sell this disappointing position. The increased number of shares for sale takes the price down to $85. The brilliant trader takes a look at this, and knows Idiot Enterprises has a great outlook for future earnings, and decides to start buying, taking the price back up to $100.

The option trader here would see the potential for an increase in the underlying price as the trend plays out, and take a position to profit. One such position would be a long call with a strike price below $100, which would be likely to move in-the-money. A second position would be to sell puts with a strike price below $85, which would be likely to expire worthless, leaving a net credit position in the trader’s account. Nice, huh?

A cup-and-handle tends to cover a long-term trend, with a year or so being common. There will be lots of subtrends taking place over that time. Weeklys won’t be affected, but options with long expirations might.

Gaps

A gap is a break in the price bars. It occurs because of a news event that usually takes place before exchange trading opens, causing a delay as everyone tries to figure out where the price should be. Or traders might be looking at overnight activity in the futures market and bidding the prices on the exchange higher or lower than the previous day’s trading range. Sometimes the gap occurs during the trading day. Some exchanges will halt if there is a sudden change in price or volume.

A gap followed by upward trading shows the news was good, which usually indicates an uptrend in the price. A gap on the down side is usually bad.

Theories of Technical Analysis

At its most basic level, technical analysis shows how changes in the supply and demand for a stock have affected price levels over time. It is a way to think about how emotion influences the prices of assets.

Some practitioners of technical analysis have developed more elaborate theories of how financial markets work and of how that activity plays out in technical patterns.

Fibonacci and Elliott Wave

The Fibonacci sequence looks like this:

0, 1, 1, 2, 3, 5, 8, 13, 21 . . .

It starts with 0 and 1, the first two whole numbers. Each following number is the sum of the previous two. Hence, 0 + 1 = 1; 1 + 1 = 2; 1 + 2 = 3. It repeats into infinity.

Something else interesting happens when the series reaches double digits and beyond:

13, 21, 34, 55, 89, 144, 233 …

That is, the ratio of each number to the next on is .618.

Look: 13 ÷ 21 = .618. 21 ÷ 34 = .618. 55 ÷ 89 = .618.

To put it another way, the ratio of the smaller and the larger of two numbers is the same as the ratio of the larger number to the sum of the two numbers. This proportion, 6.18, is also known as the Golden Ratio or Golden Proportion. It is the proportion of a perfect spiral and appears frequently in nature. It is also a key proportion used in creating art; one of the first things amateur photographers learn is “the rule of thirds,” which is based on this idea.

The Fibonacci sequence is named for Leonard Fibonacci, the Italian mathematician who discovered it about a thousand years ago. Traders often refer to it as “the Fib” for short.

This is some pretty groovy math, isn’t it? And did you think a book about options would get into rules about aesthetics?

All of this gets to trading. Seriously. One trader, Ralph Elliott, became fascinated with the idea of the Fibonacci series. He believed over the long run, the financial markets move in waves fitting Fibonacci’s equation, and he developed a system known as the Elliott Wave. The basics are these:

• A bull market has three down waves and five up waves.
• Support and resistance levels should be 61.8 percent above lows and below highs.
• Buy any underlying asset down 61.8 percent from its high.

Adherents of the Elliott Wave theory believe these movements can play out in a few hours and over centuries. They tend to look at very long-term price records. There are centuries’ worth of data for some underlying assets, such as currencies, commodities, and even stock markets.

Although it might seem nutty, and it’s not easy to learn, plenty of traders out there swear by the Fibonacci sequence and the Elliott Wave.

Candlestick Charting

The candlestick charting system was developed by Japanese rice traders more than 200 years ago, and it’s still used. Because it was developed for a commodities market, it remains popular with traders who deal in agricultural underlying assets. However, there are plenty of stock traders who use it, too.

A candlestick chart is similar to the price bar shown earlier in this chapter, but it has a wider middle section to give you more information:

A candlestick is formed to show the open and closing price for each day between the high and the low price, with the length determined by the difference between the opening and closing price for the day.

The rectangle part of the candlestick is known variously as the candle or the body. Its length gives a sense of the volatility the underlying asset. The ends between the open or close and the high and low are known as the wicks (sometimes called the shadows). The candles might be colored in to make trends stand out. Most charting apps set candlesticks to green on up days and red on down days.

Gann

Legend has it, William Gann made $50 million in the stock and commodities markets using a system based on astrology. Some say his secret died with him, while others insist he taught it to a select few. As a result, the precise details of his system are lost in the mist of time, which makes the whole system even more mysterious and more interesting.

There are two things we can say for certain about Gann. Firstly, a money management system attributed to him is popular with traders and gamblers, and it is covered in Chapter 17. Secondly, there is a system in use called Gann, which might or might not be his system.

The system currently known as Gann is based on the relationship of price and time. A Gann angle is the number of points traded per time. Hence, an underlying asset moves 2 points in 1 day has a Gann angle of 2 × 1. There are a lot of rules tied to different Gann angles, but the easy one is widely used: if the underlying falls by 50 percent, it is a good time to buy.

Putting It All Together

The value of an option is intrinsic value plus extrinsic value (time value). Time value is a function of both the volatility of the underlying and the amount of time until the option expires. Technical analysis is useful for finding the value of the underlying as well as its volatility.