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Trader's Corner

Concepts of Trend & Constructing Trendlines

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Before I get into the subject of the basic concepts of 'trend' and trendlines, especially as it relates to technical analysis, I respond to another Subscriber question of interest. In order to make an occasional explanation of my method of making trading suggestions and guidelines in my weekly INDEX TRADER, a response to the following Subscriber query is my initial topic.

SUBSCRIBER QUESTION:
" I signed up for your option investor this evening an want to know if you provide option set ups for the index's. Upon review of the Index trader, I notice you mention area's on the index's that might be attractive to place a trade but I did not notice any suggested trades."

RESPONSE:
[NOTE: My INDEX TRADER column is up on the weekend, typically Saturday, but is seen on the web site ONLY. From your Sat/Sun. Option Investor e-mailed Newsletter, there is a link near the top of the Newsletter where you can CLICK to my column, but you will be going on the web site at that point.]

I do make specific 'trades' or trading suggestions in terms of the major stock Indexes in terms of a price or area for entry into calls or puts (with a suggested exit point basis the option PRICE levels; but not a specific call/put strike price and month.
WHY?
# 1 - There are too many different preferences as to how our Subscribers like to trade, from very aggressive to more conservative in terms of close by expirations or calls or puts that have some weeks yet to expiration.

# 2 It's too much of an administrative nightmare to keep track of several specific trader recommendations involving price of the option, an exit point for that option if I want to suggest a 'stop' or exit point, an objective, relative to the option, and so on.

I'll give an example of the S&P 100 (OEX) calls and puts from yesterday's (10/18) CBOE most actives: The OCT. 555 Puts closed at 4.50, +2.35. The OCT 555 Calls closed at 1.35 2.75.

Playing options this 'close' by, with so FEW days to expiration is not my particular trading style. I like the idea of trading In The Money (ITM), but would be out in November.

I have been bullish on the OEX calls and, for those that can trade actively and watch the market, what price swings these are! Not my game, as I tend to look for moves that I think will develop over 2-3 weeks, not 2-3 days.

You can tell that I tend to be a BUYER of options. I basically have been 'timing' the stock indexes (first for all UBS brokers), taking directional trades, since when stock index futures first started. Later I switched to options when I wanted to 'slow down' a bit; I noticed anyway that my biggest 'following' was with the option brokers. Anyway, they were interested in buy or sell (direction) and in what areas (price).

MY OPTION CRITERIA -
#1 - the contract should be actively traded, so am looking for a month and strike price that will allow me to buy 5-10 puts or calls and not have the price move much.

#2 I like to have 2-3 weeks left to expiration, but don't tend to trade options that go out beyond 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!

I want to go out beyond the lead month options if there is only 1-2 weeks left to expiration. I prefer to have more time left in order to stay with a developing trend. I could roll into a higher/lower strike and go out further, but tend not too.

#3 - I try to buy an Index 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'.

#4 because of #3, I trade LESS, not more, frequently. I'm NOT your broker urging you to jump in, jump out and making commissions each time you do so. (Hey, I was one once!) I only care that I end up the year at a substantial profit. To do this, in my estimation anyway, most traders should pick their (occasional) spots only.

#5 - 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 as there tends to be these 'spike' lows or 'V-bottoms' because 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 typically take longer to form and in an advancing trend a rally can keep going for some time or index prices will tend to "hang" around resistance(s). This 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, with a month or so before expiration.

EXAMPLE - FROM MY 10/8 INDEX TRADER COMMENTARY:
" ... I'd buy (OEX) calls on dips, but am also waiting for any 1-day confirming extreme in my Call-Put 'sentiment' indicator. But assuming a call buy around 545, risk to 542 is 3 pts, versus upside back up to 559-560. (the 'risk to reward') Ratio is good."

The above comments are made after the close of trading on 10/7. This trade is only now just working out in my estimation. I preferred than, when OEX dipped to the 545 area, to go into the November 545 calls. I don't want to 'overtrade' relative to how much I have in my account and buying the more distant strikes is an 'encouragement' so to speak, for me to buy twice or three times as many calls.

Just because calls are limited RISK doesn't mean we should not be careful not to overbuy relative to our trading capital. Buying more of a cheaper call or put is not necessarily a smart trading STRATEGY. I plan on being wrong a certain amount of the time and I want above all to preserve trading capital and take small losses. I learned this stock index trading futures, which is what I did first for a few years.

THE OEX CHART THEN (when I wrote my 10/8 commentary) -

THE OEX CHART TODAY (as of 10/19)

Buying the OEX November 545 Index calls when the S&P 100 Index got down to 545 on two occasions now, even using a very 'tight' stop or exit point at 542, looks like its turning out to offer an outstanding risk to 'reward' potential. Stay tuned on that!

Today's OEX price action is what I would call a KEY upside reversal; i.e., a new low for the recent move, followed by a close that is above the previous day's HIGH. The fact that today marked a new 5-day high, even more so.

For more on why a LESS bullish/more bearish 'sentiment' level suggests this recent bottom will lead to more sustainable rally, I refer you to my most recent Index Trader Commentary (10/15), and the section on the S&P 100 (OEX), which you can see in the INDEX TRADER section on the OIN home page or go to directly by clicking here

That my call to put indicator was more 'bullish' today should be very encouraging to the bulls

For a bit more in-depth discussion of trader 'sentiment' as an INDICATOR for future market behavior, you can look at one of my Wednesday Trader's Corner articles from August by clicking here.


II. TREND and TRENDLINES

SUBSCRIBER QUESTION:
"I am new to the technical analysis mindset. I read articles like yours with great interest and with the hope that I can also see the pattern the writer is talking about.

I have one question about the chart and commentary noted in Option Investor Daily, Wednesday 10-05-2005, Hourly charts and "Double Trend line" Resistance, S&P 500 (SPX) Hourly Chart.

You have drawn three trend lines on that chart, T1, T2, and T3. T1 and T2 follow consistent drawing patterns, that is from end Aug's bottom to adjacent bottoms. T3 however, does not follow this pattern.

T3 is drawn from end Aug's bottom to the last adjacent top. Why is this? Is this a particular technical analysis technique? Can you refer me to some sort of reference material that might explain this"?

RESPONSE:
First of all let me engage in shameless self-promotion and refer you to Amazon books and my "Essential Technical Analysis". You can buy used copies. By the way, I don't benefit at all from the sale of this book, as was well paid already by John Wiley & Sons to go off an write it back in 2001. [Which is why I was NOT in my office on the 105th floor on 9/11/01 in the North Tower of the World Trade Center, along with the rest of my (deceased) Cantor Fitzgerald colleagues.]

I think the trendline section in my book is better than the others out there because I go into more depth on the valid variations of constructing trendlines.

THE CHART YOU REFERRED TO:
The first two upward sloping blue dashed trendlines below, reading from left to right and higher slope to lower, are more or less 'conventional' trendlines. I say more or less, because, unlike the most restrictive way of drawing trendlines, they 'cut through' or bisect one or more 'bars' of the chart; i.e., one or more INTRADAY lows.

An 'internal' trendline, pioneered by Jack Schwager, connects the MOST number of highs and lows and generally or 'artfully' shows the PREDOMINANT rate of ascent or descent for a price trend.

The way that the most significant resistance is shown by a down trendline is drawing a straight line connecting 2-3 or more DESCENDING rally peaks; i.e., this is the DOWN trendline. The #1 trendline of what I called 'double' trendline resistance is the red down sloping trendline below. A rally peak made close to this down trendline is seen at the 3rd red down arrow.

The 4th and last down red arrow is at the 3rd upward sloping blue trendline and is another means of showing resistance; this trendline also starts at August lows, but connects 2-3 HIGHS made over the course of the last rally, before its sharp break.

This method of connecting the highs seen in an UPTREND such as we had from mid to late-Sept, is also the way that the top end of an uptrend channel is constructed showing rising minor resistance.

On the way up, prices of stocks and indices tend have both up and down price swings, but within a rising trend. This movement tends to occurs WITHIN two rising trendlines, one drawn through the lows (the up trendline) and other through the highs (the top end of a rising trend channel). The reverse tends to be true in downtrends, although there are more straight-line declines.

MORE TRENDLINE, AND TREND 'CHANNEL', CONCEPTS
The first rising up trendline on the left in the hourly S&P 100 (OEX) chart below is drawn through rally highs and defines resistance within the rising trend; i.e., the upper end of OEX's uptrend 'channel'. This trendline is drawn parallel to the T2 up trendline that connects the various lows on the way up.

Trendline T1 is the initial rising UP trendline connecting the various lows. This up trendline had to be revised once prices pierced the steep angle of T1. The new up trendline became 'T2' and defined potential support on pullbacks. The parallel gray up trendline (to T2) defined the upper end of the rising trend channel, showed areas of periodic resistance or selling interest ('profit taking') on the way up.

An uptrend is a series of rising rally highs and RISING pullback lows. The lows 'define' the uptrend line. When there's break of this trendline, the rising trend angle then becomes less steep OR the trend reverses.

Just as prior support, once broken, tends to 'become' resistance later on, so to with trendlines. Trendline T2 was penetrated. When OEX rebounded back to that line (at the red down arrow), resistance was hit and the trend reversed down.


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** Good Trading Success! **
 

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