Archive of Trading Education Articles

Combining Technical Analysis and Options Trading
By Guy Bower of www.guybower.com*
Posted: Apr 28, 2006

Someone who regularly sells call and put options knows that the timing of an entry is a crucial part of the trade. Pricing of options themselves (implied volatility) is probably the most important factor. But, I use a combination of option price analysis and technical analysis to provide a more effective entry.

On the technical front, I use a simple two-step process:

1. Oscillators provide a good understanding of the mood of the market.
2. Candlesticks provide more accurate timing for exact entry.

Oscillators

By "mood of the market", I mean whether or not the market is overbought or oversold and, therefore, primed for a turnaround. Here, I would recommend sticking to the favorites: RSI or Slow Stochastics.

You'll find a lot of books and seminars that talk about fine-tuning parameters. "11 days is better because…", "32 days is better because…". In practice, I have found the best thing to do is pick one level and stick to it. That way, you'll get used to how the indicator behaves. I tend to use a 14-day RSI the most often. That parameter may not be perfect for all markets, but the benefit of sticking with one parameter is that you become used to the way it behaves.

eSignal has a great chart display function called Color Line Bar. It highlights the whole indicator section in red or green when the market is overbought or oversold. It's a great (simple) way to look at things when scanning markets.

Overall, the point of using an RSI or Slow Stochastic is to tell if the market is overbought (ready to be sold) or oversold (ready to be bought).

Most books and seminars will talk about using a trend filter when using these indicators. Something like the ADX is designed to tell you when the market is trending and, therefore, oscillators should not be used.

In my trading, however, I've found this to be of little use given the short-term nature of option-selling trades. Instead, I use candlesticks to fine-tune an entry.

Before we get into candles, however, there is one further factor that can give you a more reliable turning-point signal. Bullish and bearish divergences in oscillators, such as the RSI or Stochastics, will also add a level of strength to an entry. A bearish divergence suggests the market is not as strong as it has been. An overbought signal, combined with a bearish divergence, will often be a more reliable signal for a short-term bearish trade.

For oversold markets, a bullish divergence acts the same way. It suggests the bullish signal will be more reliable.

Indicator	Bearish Patterns	Bullish Patterns
RSI	Overbought signal above 70	Oversold signal below 30
Slow Stochastics	Overbought signal above 80	Oversold signal below 20
Oscillator Divergence	Even just a two-point divergence between the oscillator and the price chart, combined with the right candlestick pattern, can be a very powerful entry tool.
Moving Averages	A strong divergence between the futures price and the moving average level can signal overbought or oversold conditions. This, however, is often duplicated in oscillators, such as the RSI.

Table 1: Bullish and Bearish Divergences in Oscillators

Candlesticks

Like the Color Line Bar function, candlestick charts allow the user to recognize market behavior instantly. Lots of green bars show a strong market. Lots of red ones show a weak market. Timing of an option trade, however, requires a little more analysis, but, as with the use of indicators, we can keep it pretty simple.

For selling calls or call spreads, I will first look for overbought conditions as discussed previously. Then, I will fine-tune an entry point using bearish reversal signals on the candlesticks.

For selling puts or put spreads, it is just the opposite. First, look for oversold conditions on indicators. Then, fine-tune an entry point using bearish reversal signals on the candlesticks. Table 2 lists bullish and bearish candlestick patterns.

Indicator	Bearish Patterns	Bullish Patterns
Candlesticks	Shooting star Hanging man Spinning top Doji Dark cloud cover Tweezer top	Hammer Inverted hammer Spinning top Doji Piercing pattern Tweezer bottom

Table 2: Bullish and Bearish Candlestick Patterns

Options or Outrights?

A few times in this article, I mentioned I use this technique for entering option trades. However, it should be noted that it can also be used to trade the underlying futures or shares. It should be pointed out, though, that this is not trend trading. Candles and indicators can be used to fine-tune a short-term trade, typically, between one and four weeks.

One advantage of options over futures, though, is that a well designed option trade can be a little more forgiving than futures should your timing be off by a day or a few days. However, this trade can still work with outright futures.

Keep It Simple, Trader

Overall, this is a pretty simple application of candlesticks and everyday indicators. There are, however, many successful traders out there who do believe in keeping it simple. I'm one of them!

*Reprinted (and modified) with permission from Guy Bower, a professional options trader and advisor based in Sydney, Australia. www.option1.com.au, www.cwa.net.au and www.guybower.com

Read More Weekly Trading Education Articles.

FREE Learning Updates from eSignal Learning!