Option Investor
Educational Article

Confirmation Is Crucial

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As options traders, we have a much more daunting task to trade profitably than do stock or futures traders. In addition to being right on direction, we also have to be right on timing. Not only that, but due to factors such as volatility, time decay, bid/ask spread and slippage, we need a solid move to overcome the natural erosion in value of the option we purchase. Traders that have been involved in this game for a while understand the truth behind the statistic that 90% of all options expire worthless.

To profit from the practice of buying options with the goal of selling them later for a profit, we have to stack as many factors in our favor as possible. Another way of thinking of this is that the deck is naturally stacked against us in this game. Our defense against this situation is to only enter trades where we can see enough factors lined up in our favor that the odds our good that we can overcome the stacked deck. That is what technical analysis is all about.

Many new traders think they can find one magic technical indicator that will provide one winning trade after another. Sadly, that siren's song has led to more than a handful of busted accounts. Lest you think you're alone in that pursuit, let me assure you that I spent more late nights toiling on that path than I care to admit. The effort wasn't in vain, as I managed to cobble together what I think is a fairly solid understanding of the world of technical analysis. In the process, I even managed to craft a few technical tools of my own, that have helped me in my quest for profits over the years.

I wrote about a couple of these indicators earlier this year, with emphasis on a moving average channel system that I call the Ribbon System, as well as a technique for trading gaps. Long time readers will have a vague recollection of those articles, while newcomers won't have any idea what I'm talking about. So let's start off by refreshing everyone's memory. Here are the links to those articles, if you're interested.

New Tools for the New Year
More On The Application of Moving Averages
Another Tool For The Toolbox
Combining Technical Tools Improves Confidence and Results

Alright, that should give us all a common reference point for our discussion today. From time to time, I'll get questions from readers, asking if this stock or that one looks like an entry (either bullish or bearish) based on one of the technique I've written about in the past. Sometimes the answer is yes, and sometimes the answer is no. But it always provides me with food for thought and the opportunity to share any illuminating thoughts with the rest of you.

Earlier this week I got an email asking if AIG looked like a short, based on the signal being given by the Ribbon system. Let's take a look at the daily chart together, and see what it tells us.

Daily Chart of AIG -- Moving Average Ribbon Shown

Based on the definition of the Ribbon system, we have a quantifiable bearish entry signal as of the close on Tuesday. The daily Stochastics confirms this weakness, as it is rolling over without getting anywhere near overbought territory on this latest move. That seems pretty clear, doesn't it? But remember the topic of our conversation here today -- Confirmation. Let's take a closer look at that chart and see what other clues it might provide about the future direction of AIG.

Daily Chart of AIG -- A Closer View

Well now, hold on just a minute. Suddenly, there seem to be a lot of obstacles in the way of a profitable trade to the downside. First up is the Support near $62, with the 50-dma resting just below at $61.82. Then we have support near $61 at the bottom of that big gap up in the middle of October. And finally, the bottom of the gap should provide support near the $60 level. Not only is there substantial support just under the current level, but the weakening volume trend isn't showing any rush to get out of the stock. Certainly we might be able to squeeze out a couple $$ of profit on a successful fill of that gap, but what's the risk-reward ratio. By my estimation, it would be tough to place a meaningful technical stop much below $66 (using the hourly chart, which isn't shown). With the stock trading just below $63, that makes the risk to reward ratio just about 1:1. There doesn't seem to be anything here that is improving our odds of success. But let's take a look at one more thing before we call it quits. I NEVER place a trade without at least looking at the Point and Figure (PnF) chart to find out whether it is bullish, bearish or neutral.

Point and Figure chart of AIG

Once again, we can see that it is a stretch to call AIG currently bearish. While it has certainly weakened since late November, the stock would have to trade at $62 or below to generate a PnF Sell signal, and then there is the rising Bullish Support line at $61. Recall that the first test of bullish support is usually painful for the bears. That means that a trade down to just above $61 (the top of the gap) could very easily produce a reversal. That would show on the PnF chart as a one-box violation of the $63 support level and would be a classic bear trap. I don't know about you, but I don't like traps, at least not when they get sprung ON me.

Don't get me wrong. AIG may turn out to be an attractive short play in the future, but it isn't one right now. Before contemplating a bearish trade, we need to see a couple things materialize. First those support levels listed above need to be taken out and the PnF chart needs to generate a new Sell signal. But that isn't the point at which we want to implement the trade. With the broad market Bullish Percent readings so high right now, bearish trades need to be implemented by selling resistance on technically weak stocks. So what we'd like to do is implement our bearish trade on a subsequent failed rally below the $66 level, AFTER the PnF Sell signal is generated. Not only does that give us confirmation of the stock's weakness, but it makes for a much better risk/reward ratio, as we can set a close stop at $67. Note that after generating a Sell signal, the PnF chart would need to print $67 before going back on a Buy signal.

This column is normally reserved for options trading related educational material, and if you've been paying attention you've noticed that we really haven't talked about any options-specific material today. Or have we? As noted at the top of this piece, stacking the odds in our favor has EVERYTHING to do with successful options trading. We didn't highlight anything that looks like a high-odds trade right now, but I think we may have done something more important -- we've stayed out of a questionable trade. If we can avoid the questionable trades and only take those where we can stack the odds in our favor, we should be able to profit over the long term using whatever options trading strategy (whether long puts or calls, spreads, straddles, or naked option sales) happens to fit with our own individual business plans.

Since we've gone through this process tonight and rejected the idea of a bearish trade, my goal next Monday is to go through a similar process of confirmation, presenting a trade candidate that looks good with the odds stacked in our favor. If you've got a stock that you think looks good, then send it along for consideration. I'll look at all the candidates, along with those that catch my attention and present the one that looks the best.

Have a great week!

Mark



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