Technical analysis is the art and science of interpreting charts to make buy or sell decisions. In technical analysis, those buy or sell decisions are timed so as to maximise profit from trading. In fact, many option traders use technical analysis to determine their entry and exit points in the market. By studying the charts, traders are able to make forecasts as to the direction of a traded security or the markets.
Technical analysis can be further classified into:
- Indicator based
- Price patterns
Indicator based technical analysis
Indicators are mathematical algorithms that take all available information from price action, trading volume and other factors of an underlying security, processing the information, and then predicting the future direction of a traded security.
Price patterns are based on chart patterns that are being formed by a financial security. By studying these price patterns, the future direction of the security is predicted.
How does technical analysis help option traders?
By performing technical analysis, the options trader is able to determine with some probability of market conditions around a security is bullish, bearish or range bound. After doing so, the trader can select an options strategy to take advantage of those forecasted conditions.
The other reason why option traders may want to use technical analysis is this. Options are wasting assets. Over time, there is an erosion of time value and the option becomes worth less over time, that is the option premium decreases over time in the absence of any changes to the underlying’s price. This is reflected in the time value chart shown below.
The time value has a steep gradient over the last 30 days. Making use of this information, if a trader wants to buy a call option, technical analysis may help him decide that the price of the underlying security will increase significantly over the next 30 days in order to make the trade profitable.
Or he may make use of technical analysis to tell him that the price of the underlying security may trade in a tight and narrow band between a certain support and resistance. As such, he may write an in the money option that will expire worthless(In the money option premiums are higher than out of the money option premiums).
Another example to use technical analysis is if the potential exit price is much higher than the entry price now, and hence, this gives the trader some confidence that the option is worth holding onto right now.
Regardless of the reason, there are a myriad reasons to use technical analysis to improve the profitability of option trades. Why not? Another tool within the traders skill set may make or break his investing success.
All in all, technical analysis requires learning and experimentation. The articles that will follow will prove to be a valuable resource to all amateur option traders and do share this page with others that may help other traders enhance their skill sets.