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 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:
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

CANDLE

Positive Candle & Bar

High Close High Close

Open Low

Open 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:
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

30 Day Historic Volatility = 30%

Dec 13, 2010

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
Option Contract Cost Break Even Option value at expiration Net Profit

January, 74 strike put

$0.68

$73.32

$0.00

-$0.68 loss

January, 82 strike put

$2.70

$79.30

$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

MAY 20 - BUY PUT

SUPPORT

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. Rememberthe 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.