Option Investor
Educational Article

The Trend Is Your Friend

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By Lynda Schuepp

Trade with the trend my friend, and you will have the wind at your back instead of "in your face." Of course, you first have to define your trading time frame.

If you are an intraday trader, then use a daily or 60 minute chart to determine the trend. Then, use a 15 or 30 minute chart to confirm the trend and determine your entry point. If you are a swing trader, look at a daily chart and look at the 20 and 50 period moving averages. If the 20 is above the 50 and they are both heading up, then the stock is in an uptrend. It is even better if the 200 day moving average is below the 20 and 50 day moving averages. However, it's hard to find many of these charts these days. If you are a buy and hold investor, then you probably aren't reading this article, but your time frame would be monthly, followed by daily. I know this sounds very basic, but this is options 101 and it's a concept most of us fail to follow. You will greatly improve your odds of success, if you simply follow this rule, with some additional guidelines below.

UPTREND:
If your stock is in an uptrend, then when do you buy or sell? That depends on your time frame again, but the concept is the same in all time frames. In an uptrend, you buy the dips. It's nice to have confirming signals, like a bounce off of support, or touching the 20 moving average, and maybe a bullish candle set up, and it's really nice if volume confirms your entry. You should sell after 3 to 5 periods of upward movement and/or after your get conflicting signals. A "period" would be a day if you are a swing-trader, or an hour or 30 minutes if you were day trading. Remember, stocks don't go up in a straight line forever.

Which option strategies are best in an uptrend? The obvious is to buy calls. However, if you bought calls on Thursday when the VIX got to a high of 42, you would have been paying a large premium for the option. If your time horizon was longer term (greater than 7 days), the implied volatility will probably come back down and it is less likely that you would be profitable. When volatility, as measured by the VIX, is high, it is better to be a seller of options. In this case (an uptrending stock) you would sell puts, with the anticipation that the stock would go up and the volatility would go down, both of which would contribute to a lower option price for you to buy back the put at a profit. If you can't or won't sell naked puts then you could put on a bull put spread. A bull put spread, consists of a long put and a short put at a higher strike. That way, the extra premium you are paying for the long leg would be offset by the premium you are taking in on the short put. It is best to use at-the-money strikes for the short put, because this is where you get the most money for time value.

DOWNTREND:
If your stock is in a downtrend, as are most of them these days, then you need to short the rallies (short stock or buy puts). This is where most of us have been going wrong. We are used to buying the dips and the stocks always went up. Well, that strategy works in an up trend, NOT in a downtrend. After 3 to 5 periods of a rally, if your stock is in a downtrend, get ready for a signal to short. Again, confirming signals such as a doji (candle stick pattern), volume decreasing as price is increasing, failing to make a new high (failed tops) are all very good reasons to short in this scenario. The more reasons, the more likely you will be successful. You would then hold for 3 to 5 periods and/or a sign of a reversal and close your position for a profit at the first sign of strength. I particularly like failed tops.

Let's look at an example of a downtrend. The first step is to determine your trading time frame. I usually swing trade and day trade, using hourly charts for day trading with a 30 min chart for entry points. We will look at trading the OEX on an intraday basis. First, we need to look at the next longer time frame to determine the overall trend. Below is the daily chart and you can clearly see that the OEX is in a downtrend. Notice the 20 and 40 period moving averages are down and heading lower and the 20 period is below the 40 period, which is our criteria for a downtrend. Next, we go to a shorter term chart.

DAILY CHART OF OEX:

60 MINUTE CHART OF OEX:

In the 60 minute chart above we see that the averages are down, with the 20 below the 40. So if the trend is down on the 60 minute then we will look to short the failed rallies. For entry points we look at the 15 or 30 minute charts, depending on how long you like to hold. I like to look at the 30 minute charts and make my entry and exit based on them, so that I am not whip sawed out of a trade intraday. Sometimes that means I hold over night. The exception to this if there is surprise news and the stock is going to move fast, then I will look at a shorter time-frame like a 5 or 15 minute. We have already determined that the OEX is in a downtrend on the daily and hourly so we then look at the 30 minute chart.

30 MINUTE CHART OF OEX:

At #1 on the chart:
We see the OEX traded sideways in a narrow range for about 7 candles or 3-1/2 hours in this timeframe. These periods of consolidation, usually lead to nice moves. After the longer red candle, another long red candle followed and closed lower than the previous low, a nice place to enter the short. You could have bought the OEX 600 put for 23 points.

At #2:
Here we would cover, following the rule of closing after 3 to 5 candles and/or a reversal sign. We got both--5 down candles and a large bullish reversal candle. We would have sold the put at the close of the large green candle for 33 points, a 10 point gain.

At #3:
Here we have another example of a failed top. We would short on the close of the second long red candle. The put would have cost 35 points.

At #4:
We would cover here because there were 5 down candles and also a bottoming tail. We would have sold the put for about 49 points for a 14 point gain!

At #5:
We have a double top, however the double top did not fail, it continued to go up. Therefore, no shorting opportunity here.

At #6:
We could have a failed top here. Notice the red candle after 3 green ones. Also it is at the same level as the failed top of move #3! If a red candle forms that closes below the previous candle, then I'd be ready to short (buy a put).

Using this method, you can have some very profitable moves, with less risk. This past week however, is not typical. The OEX moved 50 points or about 10% in one week. The concept can be applied to less exciting weeks, but the profits will be smaller.

P.S. OOPS, I messed up last week in calculating the decline % -- I reversed the numbers when I subtracted and then divided to find the % change. Unfortunately, I copied the formula throughout my spreadsheet. The conclusions however did not change and the concept remains in tact.

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