- 2000: Volume 9, No. 4 Puts & Calls: Let's Get Technical

Technical analysis is built on the theory that market movement can be forecasted by looking for repetitive patterns in stock price and volume charts. The application of technical analysis in trading is virtually required in order to determine favorable entry and exit points. Moving averages and trendlines used in tandem provide useful information, but the timeline sometimes isn't as good as many would like. Here are some simple techniques designed to help the short- to very short-term trader spot trend changes as soon as possible. Technical analysis provides a host of visual indicators that can be combined to identify overbought and oversold conditions, thereby providing valuable clues for opening and exiting a trade.

Moving Averages

The application of moving averages can determine breakout and support levels. Varying their lengths can highlight trend reversals as they "crossover" one another. There are two choices available as to the nature of the MA: simple and exponential. "Simple" moving averages take the number of days called for, (a 10 DMA will take the previous 10 days closing prices), adds them together and divides by 10. Each day has the same weighting—.10. Let's say we're trading OEX front month option contracts. If the OEX drops below the 10 DMA you buy puts; above the line you purchase call contracts.

The speed of the signal given using this method is slower because of the equal weighting, which is why the usage of an exponential weighting is preferred. This method puts added emphasis on the most recent two days. These last two days receive a weighting equaling 100 percent, a common combination is .18/.82. i.e., the most recent day gets weighted 18 percent, the day before gets a 82 percent. This causes the moving average line to react much faster to recent action in the market.

A more cautious approach is to wait for another technical indicator to confirm a move, which makes sense. But if you utilize another moving average to crossover as your signal, a good portion of the move will have already occurred, meaning you either got in or got out late. This means money lost—a luxury few scalpers can afford.

The Use of Oscillators

Market conditions in the first half of 2000 have been volatile to say the least, leaving technicians arguing as to the validity of the recent rally attempts. When market trends are not clearly defined, the use of oscillators can be of great help to the trader. Trend analysis is weakest in a choppy market, but this is where the oscillator shines. It will fluctuate above and below a centerline to indicate overbought and oversold conditions. It also can warn of the loss of momentum prior to the corresponding price action.

Perhaps a trader's best use of the oscillator is the divergence from price action, as it is a better warning signal than simply keying off price action. This is most easily observed by the histogram, as it fluctuates above and below the centerline, present in some but not all oscillators.

Moving Average Convergence/Divergence

The Moving Average Convergence/Divergence (MACD) oscillator is actually two moving averages (or three, if you want to be precise) that behave as oscillators. One MA uses two moving averages, most often a smoothed exponential average of 12 and 26 days or weeks, and is known as the MACD Line. It's faster than the other line used, which averages the difference in the two moving averages that comprise the MACD (or fast) line. It's most often called the slow line. The actual buy or sell signal occurs when the faster line crosses over the slower line; this is a buy signal. When the faster line crosses under the slower, it's a sell signal.

Typical of an oscillator is the presence of a centerline. As the two lines rise toward the top of the range, this will signal an overbought condition. Conversely, if it drops to the lower extreme, an oversold condition exists. The third indicator in Figure 1 is a histogram, a bar graph that indicates the distance the two lines are from one another. It's the histogram that will be the earliest signal of a possible trend change. The shorter your time intervals in constructing the chart, the more volatile the MACD. This is exactly what a short-term OEX trader needs to detect entry and exit points for an intraday trade.

Figure 1: MACD & Histogram

Figure 2 provides an example of market action and how the MACD and histogram help signal possible turns. Just off-center in Figure 2 there's an extreme dip. The actual gap between the MACD lines and the histogram indicates an oversold condition to the extreme. (Remember, this is only a five minute chart!) See the nearly 90 degree turn of the "fast" line-a clear signal the market was going to try to rally. It seems the bears had given it an honest effort and ran out gas.

Figure 2: OEX 5-Minute Chart

This kind of condition is ripe for an OEX trader to enter a limit order just below the current bid as the histogram begins to turn. This "rifle shot" strategy can often tack another half point profit onto the trade, due to the sell-off shaking contracts out of "weak hands" as they liquidate positions "at the market." The swing back north can attract call buyers in a flurry, sending premiums up faster than the underlying index. In these kinds of conditions, it's wise to queue up the sell order, and watch the histogram closely. The premiums that inflated your contract on the way up will undoubtedly come back to normal when the rally loses steam.

For those that don't care to split hairs by the minute, choosing instead to look at the "bigger picture," Figure 3 illustrates a daily perspective. The MACD lines cross well before the moving averages cross. It is interesting to note that the histogram in the MACD study forecasted a change in market direction well before the fast and slow lines of the MACD crossed. In any case, the addition of the MACD oscillator signaled well ahead of time the turns the market would take.

Figure 3: OEX Daily Chart

Spreads and Covered Calls

The MACD oscillator is a great aid to spread traders as well as covered call writers, since trading range extremes are more evident, and turns more predictable. Some brokerage firms require the spread trader to "leg into" the position if he doesn't purchase 20 or more positions. With the help of the MACD oscillator, intraday swings are more evident, thereby providing both lower call or put purchases, as well as higher prices for the other side of the spread.

Figure 4 shows how the price swings could be of benefit to both the directional trader, spread trader, or covered call writer. Naked puts are also a possibility if you're so inclined.

Figure 4: Dell Daily Chart

It's also important to consider the nature of the market in the examples shown. Markets were extremely volatile during this period. Some of the most memorable days anyone has seen occurred in early April 2000, when the Nasdaq plunged and rallied with a vengeance. Oscillators are more reliable in choppy markets than in breakouts to either the upside or downside. In the case of a breakout, where a major new trend begins, the oscillator will signal an overbought condition before and after the breakout, riding the upper boundary of the band for a period before adjusting.

Figure 5 shows how a stock (or index) in a definite trend, up or down, can diminish the practicality of the MACD. The lines climb above the histogram. Signals are still offered by divergences, but the safer way to take advantage of this situation is to buy the dips. Even though it looks like an EKG for an anxious person, (i.e. it's trendless and erratic), the MACD is a reliable technical tool.

Figure 5: Micron Uptrend

Technicals offer traders innovative approaches to assessing chart patterns. Use of a variety of technical tools can identify bullish and bearish trends, as well as overbought and oversold conditions. It's up to you to employ the appropriate low risk options strategy that takes advantage of them.

Mike Keller is a senior writer andtrading humorist at Optionetics.com, an educational firm dedicated toempowering investors through knowledge. Questions and comments can be sentto mikekeller@optionetics.com.