Options traders of all levels and experience want the best chance of making profitable trades and mitigating their losses.
One of the most critical and essential components of successful options trading is understanding and applying trend analysis in the markets.
Trends tell us what has happened in the market, what is currently happening, and hopefully, tell us what will happen to trade effectively.
Now, trend analysis is not a crystal ball that will tell you what trades will succeed and which ones will not. However, identifying some key metrics and learning the basics of technical analysis will help you make educated decisions with your trades and ultimately help you develop your trading ability.
Today, Lantern invites you to learn some of the most common technical trend indicators and how to apply them to your trading methodology.
Support, Resistance, and Breakthroughs
Before we dive into trend analysis and trading application; we need to understand what trends tell us. As options traders, we want to know when a security is reaching a top price point, if it’s bottoming out, or if it’s about to reverse its moment and change direction.
This is where support, resistance, and breakthrough points come in.
A large component of technical analysis is understanding trends in buying and selling patterns. Support lines are usually the bottom of a downward price trend.
For example, a stock that is trading at all-time highs around $150 begins to lose momentum as some investors decide to take their profits, and the stock drops to $140, $130, and then hovers between $120-$125.
In this example, the support is probably around $120, which means there are enough buyers interested in the stock, so it probably will not drop below $120 throughout this trend.
If support levels prevent a stock from dropping any further, resistance levels are identified as prices where a stock has a difficult time going above a specific price.
Selling pressure usually dictates resistance levels because there may be more sell orders at a specific price. Investors are taking profits or do not believe the stock is worth more than that level.
Breakthrough/Breakout points are when there is enough buying or selling momentum to either go over the resistance point or below the support level.
Traders are very interested in the amount of trading volume required to reach a breaking point because many of their orders and trading positions rely on accurately predicting the breaking points.
Trend Lines and Trend Channels
Trend lines are composed of three different points on a stock chart that illustrate a positive trend where the stock is going up or a negative trend where the stock price is going down.
Strong Trends are easy to identify because the price is moving dramatically in one direction.
However, when the share price bounces around and is not behaving definitively, this is called a neutral or non-trending market because the trend is not easy to identify.
Trend channels are similar to trend lines. However, they have a top and bottom to help find the range of price movements in tandem with the support and resistance levels.
Different traders rely on various technical indicators to decide where the price might go in the near to medium-term. We will go through some of the most popular indicators that you can put into practice today.
The put-call ratio is one of the most popular, standard indicators that help gauge market direction. It is calculated by dividing the number of traded put options by the total number of traded call options.
This is one of the most common ratios to help investors determine the market sentiment for a stock.
Relative Strength Index (RSI)
The Relative Strength Index is a technical indicator intended to chart current and previous strengths and weaknesses of various stock prices. The RSI is calculated from the closing prices throughout a recent trading period.
This index was developed by Welles Wilder, an influential technical analyst. The goal of the RSI is to compare the magnitude of recent losses and gains over a specific period.
RSI is a momentum indicator that measures the speed and change of price movements in a security. Traditionally it will move between a range of 0 and 100.
If the RSI is above 70, many investors believe that the security in question is overbought, leading to a profitable selling opportunity. If the RSI is below 30, investors may consider the stock to be oversold.
If too many investors are dumping an otherwise healthy stock, then there is a good reason to believe that they have reached an optimal entry point.
Intraday Momentum Index (IMI)
Traders who employ high-frequency strategies enjoy utilizing the intra-day momentum index because it helps identify trends for intraday Trading.
The goal of the IMI is to spot potential opportunities to engage in bullish trades when the market is trending up during an intraday correction or to initiate a bearish trade when the market is trending down after an intraday price spike.
They are open interest gauges for stocks, options, short positions, and more. When options traders look at open interest, they are looking for the amount of open and unsettled contracts in the market.
Although open interest is not a perfect indication of up or down trends, it does provide some information regarding potential strength in different trends.
For example, when open interest increases, new capital is being pumped into that security, enhancing the sustainability of the existing trend; conversely, open interest that is declining indicates a trend that is losing Steam.
Hopefully, you will better understand the difference between fundamental and technical analysis and why technical analysis is essential for options traders.
Support and resistance levels create an average trading range where an underlying security will typically remain unless some catalyst makes a breakthrough and changes its trend.
Options trading can be confusing; that’s why Lantern wants to be your confidant in the market.
Let us know what you think about this article and what topics do you want us to discuss in the future!
If you liked this article, check out our app on the app store.