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Trader's Corner

A Trade and Trend Checklist, Part 3

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I've written quite a bit on Pattern, the P word of my "POVS" checklist. For going into, staying in and deciding whether to exit an index option trade, I need a mental checklist to not forget to look at the (chart) Pattern, Overbought/Oversold indicators (Oscillators), Volume and Sentiment.

My last Trader's Corner article can be viewed here

This article covers the concepts of overbought and oversold by using Oscillators like RSI (Relative Strength Index) or (slow) Stochastics - what I think is an effective use of them in making trading decisions. Next time I will describe a Volume indicator that gives an idea, ahead of time, that a significant S&P or Nasdaq bottom is being made. (Not about individual trading volume on an Index or a stock.) Also, an explanation of the Call/Put indicator you see every week in my Index Wrap, such as my last one, the 2/13 Index Trader wrap viewed here.

BUT FIRST A WORD FROM OUR SP0NSOR
That is, a question from one of our Option Investor Subscribers, whom we toil for -

QUESTION:
I'm never quite comfortable deciding which strike price, expiration and so forth is best to use. Even though I usually only hold them for a few days to a few weeks, I tend to go with an expiration that's 2 or 3 months away (comfort zone) and I try to stay 1st in the money, or 1st out of the money.
1. Would you please tell me what you usually do?
2. Will using QQQ's with NDX parameters work okay?
3. Do you have a minimum that you use for "Open Interest"?
4. Do you have a minimum that you use for "Volume"?

RESPONSE:
Let me start with the easiest to answer - your questions 3 and 4. I don't have a "minimum" average daily volume and open contracts number. However, I do have the criteria that the contract be actively traded, so am looking for a month and strike price that will allow me to say, buy 5-10 puts or calls and not have the price jump substantially on such a trade - which is relatively small.

I don't however, go out beyond about 4-6 weeks. You may be paying a greater time premium than is necessary assuming your TIMING is good - timing is, as they say, everything!

Probably like you from the way it sounds, is that I tend to buy markets at what I think is a significant high or low point, at their infrequent extremes - when the index or market is either quite oversold or overbought.

I want to go out beyond the lead month options if there is only a 2-3 weeks left to expiration. I prefer to have 4-6 weeks left to expiration and be able to stay with a trend, if one develops in the direction I anticipated.

If I think we're at a bottom, I tend to buy At The Money (ATM) or slightly Out of The Money (OTM) calls. If I think the market is at a top, it becomes a bit trickier.

Bottoms are "easier" in a sense. Selling tends to be more of a once or twice decision among the sellers. Whereas there is multiple and piecemeal buying of stocks on the way up, selling tends to be more emotional and investors/traders exit frequently all at once - sell everything, get me out of the market kind of thing. This dynamic creates a bottom that is often a one-time spike low - of course, sometimes you get a retest of the low and get a double bottom or a slightly lower low, then it rallies.

Tops can take longer to form and in an advancing trend a rally can keep going for some time - this is where you see rolling tops. The indexes tend to "hang" up there and it makes timing of put purchases a bit different. I am more inclined to buy half the number of puts I want to end up with and have room to buy more, perhaps to price average. I am more inclined to buy ATM or In The Money (ITM) puts. Again, I will tend to go out a month or so.

Now, what I am writing about in each and every Trader's Corner (currently on Wednesday) is HOW the heck you can find those significant rally highs or downswing lows. This is a longer story - you could get my book for example - there was enough of a story in market timing to motivate me to write "Essential Technical Analysis".

Lastly, you need to look at QQQQ to some extent as a SEPARATE market or chart. However much it tracks the Nasdaq 100 (NDX) - it is the NDX tracking stock. But the chart pattern may be clearer on NDX; or, on the Q's. For example, the $38 level appears to me so clearly to be key overhead resistance, whereas 1550 in NDX doesn't leap out at me so much.

Also, QQQQ given the sizable volume of the stock may not move proportionately as much as the underlying index. NDX will tend to overshoot technical targets more. Lastly, QQQQ has a very KEY element that you can chart - daily volume. For example, there was this amazingly clear price/volume DIVERGENCE a while back that was such a good advance signal for a short -


 

AND, ON WITH OVERBOUGHT/OVERSOLD CONCEPTS -

RSI (the Relative Strength Index) and Stochastics are considered to be both indicators of momentum AND indicators suggesting levels that an index or stock is at an extreme or "overbought" or "oversold" - what these terms mean varies a good deal. OVER-bought and OVER-sold always have to be qualified some: what is meant usually is that a stock or index is thought to be at an EXTREME on the downside or upside. We need keep in mind that an Index (or stock) is that way only in terms of TIME and CONDITION.

TIME -
Here we are looking at whether we are talking on an intraday chart (e.g., hourly), a daily chart or weekly; whether we are talking short or longer-term and is that on a 5-day, 2-week or 2-month time frame?

A so-called extreme is based on some period of time. OEX might be thought to be quite oversold because it went down sharply down for 5 straight days. However, this might be in the context that the index went up strongly for 5 straight weeks.

Shown below is a chart from the fall (10/14/04) of the Nasdaq Composite (COMP) that I marked up using the Relative Strength Index (RSI) indicator, one of the two main types of overbought-oversold technical indicator (also, a technical "study"). The fluctuation that the RSI can make is between 0 and 100, although an index rarely registers much over 75 or below 25 on a daily chart, especially if the common 14-day setting is used as below -


 

I've highlighted each time the RSI reached a peak or the first time it did so. You'll notice that I have created an overbought and oversold RANGE or bands that are between 30-35 on the downside and approximately 63-70 on the upside.

When I observed that tops in the Composite during those prior months were being reached at 63 and above, I set the lower number there, but this will vary depending on market conditions. An important thing to note is that most charting programs will have a SINGLE line that is set for the two extremes - usually, 30 and 70 in the case of the RSI indicator.

By use of a "level-line" marking tool (i.e., the dashed lines) and hopefully your charting options include this, I created a range of values for overbought and a range of values for what I am defining as oversold in the chart above - this is not a wide range, but a few points can make quite a difference in the RSI. Again, overbought and oversold are relative concepts, not absolute. So, there is no one (absolute) number that says a given index or stock is at an extreme. It's when it gets in a certain range.

HERE'S THE CHART AGAIN -


 

You'll notice that there are several instances when the RSI got into the overbought or oversold range two or more times. So, how is the RSI useful in trading?

#1 - use of the RSI or another like indicator gives you an idea that the market is VULNERABLE to a reversal - the index or stock may reverse within a few days or it might be within a couple of weeks; e.g., 8-10 trading sessions. Now, of course, this is an eternity to a shorter-term trading, especially in
options.

#2 - by the time a second extreme reading is made, almost always by 3 times, this is usually a top, especially in a trading range market like the above period.

A trading range market is one that may have wide-swinging trading swings, but is not going up or down mostly, month after month or quarter after quarter. In the above chart, COMP has traded between 2150 and 1750. While the overall trend is down during this period since each top has peaked at a lower level than the prior high, this market is trading in a wide range on the way down. Each bottom and top is not that far below the prior one.

The best use of an overbought-oversold indicator like the RSI (another is the stochastic indicator) is in a market like the one above - a trading range where, once the market gets to an upper or lower extreme, it will before too long start in the opposite direction, until it reaches an extreme in this opposite
direction.

#3 - when the RSI is at an extreme, it puts you on high ALERT to watch for OTHER signs of a reversal; e.g., a double top or bottom; a new high followed by an immediate sharp decline the same day or over 2-days (bull trap reversal); or, a new low followed by an immediate sharp rebound the same day or over 2-days (bear trap reversal).

Confirming signs of a reversal in the chart pattern, is usually a good basis on which to take a trade, and even to go in more heavily on the trade. Not all trade "set-ups" are equal - some warrant more employment of trading money, others less, within risk management prudence of course such as never trading with all your trading account.

#4 - to look for an RSI extreme is to find those occasional instances where a bullish or bearish Price/RSI DIVERGENCE sets up and this brings me back to the time period that was circled in the chart above and is reproduced in close-up below -


 

In the period shown in the chart above (late-May to late-June), a bearish Price/RSI divergence occurred where PRICES went to a new high, but where the RSI did not ALSO go to a new high reading. Therefore, this bearish divergence seen at the second high was an excellent indication to buy Nasdaq puts, even if using the Nasdaq 100 options.

I'll provide a very recent example of a price/RSI divergence -


 

One thing to be aware of with the HOURLY chart divergence shown above in the S&P 100 (OEX), is that this is an hourly chart. This is a shorter term divergence and may signal only a short-term correction, if that. Sometimes of course price/RSI divergences lead to significant trend reversals (e.g., 15-20 points or more), but the significance of such technical divergences is far greater when the divergence appears on a DAILY chart. However, this one above bear watching, as there is a possible double top setting up - stay tuned! And time will tell.

What we expect is that an indicator like RSI, will tend to "confirm" what price action is doing. If it doesn't, it's not confirmation, but "divergence". The reverse situation - a BULLISH Price/RSI divergence is seen below in the Dow 30 (INDU) WEEKLY chart -


 

Divergences are considered valid when they occur within the same time frame as the indicator is measuring. "Length" on the RSI indicator above is set to 8, meaning it measures 8 trading intervals, in this case 8 weeks. We usually then are looking for divergences that occur within this same 8 week period, but the one above occurred within 12 weeks - for a weekly chart, I like using the 8-week length setting and because the same divergence showed up on the 13-week RSI, I allow the use of the shorter length setting above as the divergence is so clear cut.

Getting back to TIME considerations - when you hear someone say the market is overbought or oversold, you should next think about what time frame they are they talking about, assuming they KNOW what they are talking about and not just repeating something that they have heard.

If you own puts, trading for a short-term decline, knowing the market is in a long-term oversold condition only suggests that you not end up turning a trade into a "position" by owning puts for more than the short-term downswing you're looking for.

CONDITION -
I started out talking about "condition" as also being a consideration about what it means when a stock or index is overbought or oversold - these terms mean different things in different market conditions or different types of markets.

Overbought and oversold as concepts are best used when a market is in a fairly defined TRADING RANGE as seen above (so far) in the OEX hourly chart.

In a runaway bull or bear market, the concept of "relative" really comes out. In a strong bull market bull or bear market, the market is going to get overbought or oversold and STAY that way for long periods of time - making the indicators that measure overbought/oversold, less useful for trading purposes. The below chart uses the 14-day RSI (i.e., 14 is the "length" setting) -


 

In the conditions prevailing in a strong bull or bear, the
overbought/oversold concepts, especially in the indices, are less meaningful. You can see that after the 2003 advance shown in the above chart, the Dow (INDU) was NEVER really "oversold" according to this convention way of measuring it with the RSI.

The same is true in a bear market, where the RSI never gets to an overbought reading - too many sellers waiting to pounce on it! The conventional technical indicators that attempt to define the relative concepts overbought and oversold are going to say that the market is oversold, and oversold and again, oversold!

SOME BASICS -
An index, or an individual stock, is commonly thought to be overbought or oversold when prices have an advance or decline of a degree that is greater than what is normal or usual relative to its past price behavior for a certain time frame and condition.

Take the case of a stock that for five months, or 5 years even, has never traded at a price that was greater than 10% of its closing average for the prior 200 days. Then comes a period when there is such a steep advance that the stock reaches a price that puts it 20-25% above this same average - this stock may be considered to be "overbought". Overbought here implies simply that any surge in buying well in excess of what is usual on an historical basis, also creates a likelihood that the stock price will correct.

Another example of an overbought condition might make an assumption about an Index that has closed higher for 10 days straight - if this price behavior is "over" or beyond what is usual for this item, the assumption is that prices are vulnerable to snapping back - a rubber band analogy is a good one, as market valuations get stretched, so to speak, but then tend to also come back to a mean or an average.

The concept of overbought and oversold refer to rallies or clines that are steeper than usual, but the degree of this can vary a good deal in terms - there is no precise, objective or
agreed upon measurement.

RSI and STOCHASTIC Indicators -

Both are also called "oscillator" type indicators in tha both are constructed in a way that the numerical scale goes from a low of zero (0) to a maximum high of 100. (This is not the case in the Moving Average Convergence Divergence or MACD; "mack-dee".) They oscillate in a fixed range. Both RSI and Stochastic measure price momentum.

The Relative Strength Index, usually referred to as the "RSI" was developed by Welles Wilder back in the '70's. A simple way to understand the RSI is that it is a RATIO (one number divided by another) that compares an average of up closes to down closes. There is only ONE variable, which is the LENGTH or the number of periods (hours, days, weeks, etc.) that the RSI formula works with.

The common RSI default (the preset value) for length in charting applications is usually either 9 or 14. The relative strength index calculations will be based only on the number of closes specified as the length setting. The reason for the widespread use of either 9 or 14 is mostly a matter of convention. Obviously, a setting of 9 or 14-days does not even represent an even number of 5-day trading weeks.

However, both 9 and 14 are common default settings and there is a repository of experience among users of the RSI with these levels and instances of overbought or oversold conditions associated with them. The commonly used default settings are 30 to represent an oversold reading and 70 and above to suggest an overbought condition.

The optimum length settings are a function of your time horizons relative to trading or investing. 5 to 9 (or 10) for the RSI length on a daily or hourly chart is appropriate for the minor trend and short-term trading. A length setting of 14 up to 21 for daily charts is good for looking at the longer trend, such as over 2-3 weeks or more. On weekly charts, my preference is an 8-week period for the RSI - 8 represents a 2-month period or 1/6 of a year, providing a relevant picture of the secondary or major trend.

RSI is derived by calculating the average number of points gained on up days, during the period selected (e.g., 14), then dividing this result by the average point decline for the same number of bars - this ratio is "RS" in a 14-period formula for RSI or 100 - 100/1+RS. RS = the average of 14-days' up closes divided by an average of 14-days' down closes. 9 or 21, or any other number, would be used instead of 14 in this example.

Every up close during this period is added and this sum is divided by the number of bars that had up closes to arrive at a simple average. Every down close during the period selected is added, then this sum is divided by the number of bars that had down closes. If 10 of 14 days had up closes, the result of this division is a ratio that rises rapidly. Subtraction from 100 of the result of the division is what makes for a scale of 1 - 100.

In a period of a rapid and steady advance the RSI will reach levels over 70 rather quickly and RSI can then remain above 70 for some period of time. The reverse is true in a decline, as readings under 30 are seen.

SLOW STOCHASTIC -
The stochastic indicator is calculated in a different way than RSI and is LESS useful in finding a divergence like the one above that was based on using the RSI.

Technical indicators can be generally grouped into trend following type indicators like moving averages, or into indicators of this type called "oscillators" that are formulas when graphed, move back in forth in a range from 1-100.

The central idea or concept of stochastics - what it is attempting to show - is that in an up or down market trend for any number of trading periods (e.g., 10 hours or 14 days), prices will at times move away from the lowest low made during that 10 hours or 14-days, or the highest high, at an increasing rate - this "rate" or speed of price changes is what the (slow) stochastic oscillator is showing visually.

The stochastics "default" oversold and overbought levels are typically pegged at readings at or below 20 and at or above 80. The stochastics tend to have wide-ranging fluctuations between 0 and 100; e.g., a low at 5 or 10, a high at 90.

The stochastics indicator is composed of two lines - a slower line called the percent D (%D) line is a simple moving average of the faster %K line. The two lines of varying speeds lead to crossovers that generate buy and sell "signals" -

Lets look at the SAME 2003 period as shown in the Dow chart above only adding the 14-day Stochastic model for comparison -


 

CONDITION -
It's a bull market! Therefore I want to skew the overbought and oversold readings UPWARD and consider above 90 in the Stochastic to be (relatively)"overbought" and at or between 40 and 30 to be "oversold". And, with these parameters in mind, there are a few useful indications of buy points, at the maximum extensions of the pullbacks, in which to help me with a few instances of buy side or bullish trades in calls.

The Stochastic study looks at the current price in relation to the highest high or lowest low in the period being measured. Stochastics plots the current close in relation to the price range over the length set for this indicator and gives this a percentage value.

The initial calculations for a stochastic of 14-days are twofold, establishing a "fast" and "slow" line. The fast line or "%K" formula is 100 - (the close minus the 14-day low) divided by (the 14-day high - the 14-day low; i.e., the price range). The slow line or "%D" (here called "FastD") is equal to a 3-day average of "%K". This first formula is referred to as the "fast stochastic" model.

The "slow stochastics" variation of the basic stochastics formula is simply to take the "FastD" figure and apply a "smoothing" calculation yet again, which results in another line which we can call "SlowD", to differentiate the two versions of "%D". The important thing to remember is not this "alphabet soup", but the fact that the slow version of the stochastics oscillator (slow stochastics) is the version that is in most common use and is most likely what you will be using if you choose the stochastics indicator to apply to a price chart.

SUMMING UP -
Best use or most effective use of oscillators is in a market with two sided trading swings, rather than one in a strong bull or bear trend. Best single oscillator to use??

RSI, in a normal trading range market, as its use will also best highlight bullish or bearish divergences. In a strong trending market on the other hand, use stochastics for the few useful signals that suggest that brief counter-trend price swings are likely to have run there course.

NOTE -
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

Good Trading Success!!

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