Option Investor
Trader's Corner

Using Trendlines To Find High-Potential Trades

HAVING TROUBLE PRINTING?
Printer friendly version

These are responses to two OI Subscribers' questions, both relating to determining market trend.

OIN SUBSCRIBER QUESTION:
I recently read your article on trendlines in The Option Investor Daily Trader's Corner article. I found it very informative and essential which leads me to two questions I would like to ask. The first would be where can I obtain a copy of your book Essential Technical Analysis.

The second would be as to how I can use the trendlines to place buy and sell orders. I have noticed that the price can sometimes sit near a top or a bottom or even break through a channel only to quickly reverse and enter the channel again.

Then of course, there are the times it just simply bounces off the line and goes right to the next like we expect it to do, those are easy. How to we build a trading plan to allow for the two?

RESPONSE:
Buying my book is no different than you would any other; e.g., ordering via amazon.com

TRENDLINES
The trading plan to use when trendlines do what we "expect it to to do" is the same as when they don't. If I'm buying calls when prices penetrate a resistance trendline, I want to risk to just under the trendline, as it should not be pierced again. If the trend works out, that is a winning trade. If it does not that is one of my losses. The trick is to keep losses SMALL! You've heard that a million times!! What is small to one is not so small to others.

Let's define what "small" or reasonable and expected losses are. They are small in relation to the potential profit. If an Index has been in a steep downtrend for some weeks and then rallies strongly up through a trendline, the rubber band effect (and past market behavior) is going to tell us that prices could bounce back some distance. Why? The sellers are all cleaned out. Pretty much everyone who was going to sell stock did so already.

So, lets say the trade ends up with us buying OEX calls, after the S&P 100 Index has fallen 30 points and AFTER the index has broken out ABOVE a resistance trendline; I assess upside potential to be for a rally of half of the decline, or 15 points. That's a reasonable expectation based on looking at the market through diverse cycles and types of markets.

If I am buying or selling near a trendline, I can risk a small amount as I have a reference point for my stop that makes sense in terms of common market action.

The basic bottom line answer to your question is to use stops, use stops and use stops. There may be 50 percent or half FALSE "breakouts" above or below valid trendlines. By "false", I mean that prices reverted, as you say, to being BACK in the trend channel.

In the chart below, the hourly S&P 100 (OEX), buying OEX calls was suggested by the price breakout at the circle. Buying calls here runs the risk that OEX will fall back INTO its price channel. How to protect against this?

The answer is simplicity itself. Exit the trade if there is a close under the top of the downtrend channel later on. If the trend has in fact reversed to up, the index will not close back down IN the channel and support (noted at green arrow) should contain sell offs

What was resistance is assumed to be a new support area. Let's see what happened next

The OEX during the late-January to early-March time frame rose from the 563 area to 585. The lower trendline was the obvious low end of the hourly uptrend channel and when it was broken at the second yellow circle it suggested exiting calls and taking out OEX puts.

But how to protect yourself in case the index popped back up back INTO its uptrend channel, which as you point out it has a disturbing tendency to do? Buying puts in the 580 area, your initial exit point on those puts is just over the red down arrow at 584. Since I estimated that OEX could fall to 565 or 15 points, a 5-point "risk" was a one to three ratio risk-to-reward ratio; 1 in 3 or better, is what I prefer. Risking one dollar for every 2-2.5 dollars (you hope to gain) is ok, but 1:3 as a threshold is better.

Once a downtrend is "confirmed" by the rally failure at point "a" on the charts, your protective exiting stop point is lowered to just above rally peak 'a'. As the OEX trend cascaded down, it was then a question of what your trade objective was.

Further "confirmation" of the downtrend came as rally point 'b' stalled shy of the prior price peak 'a'. Now I could start to drawn a downtrend channel

The parallel lines to form a downtrend price channel came after there was a low AFTER rally peak 'b'. Since I had 3 points to define a down trendline, I could draw a preliminary downtrend CHANNEL intersecting the first downswing low. Later lows fell to the trendline also. Imagine that.

Until, that is, the period shown in the circled period noted 'a' in the chart below when prices seem to slip under the lower line. Which is unimportant as the lower channel line is only an approximate area where sells off could find buying interest.

Assuming long OEX puts in the 580 area, there is no market action warranted until either a downside target is reached OR there is breakout ABOVE the down trendline, suggesting an upside reversal. If I did not take profits on my puts during the sideways slide at 555, exiting at 561 or just above the violated down trendline, is a protective given in the way I trade.

Assume a buy of OEX calls on the upside trend reversal at 561. The exit or "risk" point is to just under the broken trendline; as long as that amount is not more than 1/3 of what I hope to make on my calls. On this basis, an exit point of 558 is warranted, not lower. With the eventual dip to the 556 area, I would be out of calls if I was faithful to my trading plan.

There might have been factors that then suggested I re-enter my call position but that's another story.

OIN SUBSCRIBER #2:

Your commentary remains a valuable part of my learning about identifying tradeable trends. My question is "How can I judge if I've waited too long to act on a trend?"
The current situation is a good example (as of 4/18/05). The direction of the indices appears to certainly be down now. Is it too late to short? My sense is that in order to make any money and minimize risk a trader now has to wait for some kind of bounce to develop in order to have acceptable risk/reward potential.
RESPONSE:
You guess at it correctly you have waited too long to act on a trend IF potential trades don't meet a favorable risk to reward assessment.

In a sense you've never waited too long to trade WITH the trend, as long as its intact. I also agree with what you say about it being necessary or advisable to wait until "some kind of bounce" developed so that risk-to-reward would be acceptable.

It's hard to quantify what "some" is; i.e., how much of a rally must develop to play the short side (e.g., long puts) and not take too high of a risk given how far the market has already come down in this recent instance. Sometimes you need to pass on potential trades.

There is a tendency when we "miss" a sizable market move, to be too over-eager to get in on this new trend; to have another trading opportunity. We get blinded by greed rather than "fear", which we would do so to speak if we took as much notice of the risk in bad timing in getting in too late, such as when the market could be due for a rebound.

Pictures are worth a thousand dollars... er, words

Was it worth it for example to buy index puts around 552, after the rebound in the S&P 100 (OEX) went from 546 to the 552 area. Not for me! The only "logical" exit point would be above 560, or above its down trendline.

By some ways of measuring it, a downside price objective I had for 543 was already near at hand. 540 was also where I pegged some significant support. Downside potential was from around 552 to perhaps 542, for a 10-point "reward" potential, assuming I got puts bought at the recent rally peak.

Against this I ought to give my puts the benefit of the doubt UNLESS there was a close fully 8 points higher than my entry or above 560. With this assessment, my risk is 8 points, reward is 10 for a risk to reward of 1 to 1.25; quite far from my 1 to 3 screening. Screening trades for their risk-to-reward potential is as important as any other considerations.

Consideration examples: yes there is still "potential" profit in puts. Yes, the market is weak; yes, further events could happen to take us lower; but ... do I have a risk point that makes sense and not just some random point? ... Is profit potential 3 times or more than that?

Contrast these two possible trades, involving shorting QQQQ

Trade #1 you short the stock on a return to the down trendline or when the Q's reach the 36.5 36.7 area; risk can be held to a very small amount, as even a relatively minor breakout above the down trendline would cause me to want to exit a short play here.

I would have assessed downside or profit potential as to the lower trend channel boundary (at the first green up arrow) or around 34. If I was short above 36.2, my exiting buy stop would be 36.9 for a risk of 70 cents, versus profit potential of 2.2; an OK risk to reward.

Contrast with Trade #2 -

I short the stock around 35.2, assuming I rightly see that upside momentum is running out of steam. QQQQ then breaks its minor up trendline at 35. I get short the stock on a bounce and am lucky enough (I think) to be short at 35.2.

Is risk to reward ok? I can risk to a new high above 35.30, but that is just a guess. Is 35.3 significant technically in the next 2-3 days after I'm short? Not based on the chart.

Only a move above 36.5, to above the down trendline is significant for possible trend reversals based on chart considerations. If I am to follow the logical stop point, I should have a buy stop (liquidating) order at 36.7; for a risk of $1.50. For downside ideas, how far to the lower channel line?: to around 33.75. If so, this makes reward potential equal to $1.45.

You get the picture! Reward potential here could be LESS than what you got to risk with an exiting stop; at least one that makes sense on technical points and that is the way that I trade. Others trader differently and may make it work for them and have profitable years in options.

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!!
 

Trader's Corner Archives