Option Investor

Covered-Calls 101

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More Charting Basics

There are many steps involved in the position selection process for the Covered-Calls System. The tasks involved range from option price scans and fundamental valuation to in-depth technical analysis. One of the key procedures requires the study of moving averages and trading volume to establish a list of stocks with favorable momentum. Since these indicators are excellent tools for new traders, a review of their basic components is in order.

Trends, Moving Averages & Trading Volume

To be successful in the stock market, it's important to understand how to project future trends. In any exchange system based on supply and demand, there are three primary stages or phases of movement. These three phases consist of a basing or range-bound condition, an upward slope or growth stage and finally, a segment where buying interest becomes exhausted. Some experts refer to these conditions as the accumulation, markup, and distribution phases.

The principal objective of trend analysis is to look beyond the daily gyrations to identify the overall direction of the underlying asset. The changes in the rate of vertical (price) and forward (time) movement can be approximated with the smoothing effect of a moving average. The basic definition of a moving average is: the mean price of a security or financial instrument at a specific point in time. With this type of analysis tool, a shorter time span produces a more sensitive indication while a longer time span reflects a smoother history. The moving average offers an objective method for defining support and resistance and it can also help isolate cycles and identify overbought or oversold conditions. Some traders use moving averages to render buy and sell signals, based on multiple histories plotted on one chart. Indeed, the crossing of moving average lines; a major topic in the study of stochastics, is a very popular method of recognizing trend reversals.

There are very few technical analysis tools as versatile as the moving average however depending solely on this indicator is comparable to using the hour hand of a clock to check the time of day. It provides a good approximation of the time but offers little guidance for specific appointments. In practical terms, a moving average will help you discern whether the primary trend is up or down but it does little to help you identify effective entry and exit points in a particular issue. To be profitable on a consistent basis, you need to know where the instrument is in its current cycle. Is it in the accumulation phase, markup phase or distribution phase? The movement of a specific issue is generally determined by the intensity with which the shares are bought or sold. One method of measuring this effect in a prolonged trend is to use a moving average on transaction or trading volume.

Trading volume, or the number of shares traded, is an important indicator in interpreting market direction and stock price. The change in stock price is the result of supply and demand; those who want to buy versus those who want to sell. The key point is that a rise or fall in price on a small volume of shares traded is far less important than a move supported by heavy volume. If there is heavy trading on an upward movement, buyers control the market, and their enthusiasm for the stock often pushes it far beyond a reasonable value. Experienced traders know that rising volume generally accompanies any substantial change in a stock's price and that is an important characteristic to be aware of when reviewing market trends.

When combined with a moving average of trading volume, a simple moving average can help confirm that the market is transitioning into a condition of accumulation or in the case of a failed rally, a new distribution stage. Of course, there are often chaotic and choppy transition phases between each cycle and those intervals can be very difficult to evaluate. The type of indicators that work best during transition periods include the Moving Average Convergence-Divergence system (MACD) or exponential (weighted) averages, both of which are designed to be more sensitive to quick changes in market direction.

Investors who develop a comprehensive background in technical analysis can use intricate moving average combinations to formulate different timing methods for entering and exiting the market. For example, one unique entry system is based on signals from a short-term MACD and confirmation from the moving average of the volume indicator. Similarly, some exit strategies use the convergence between the price action and the volume average or diversions among different moving averages. Blending diverse mixtures of indicators is one way to discover the best system for your style of trading and for new investors this approach can result in a unique set of tools and intuitive techniques that will help you achieve profits on a regular basis.

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