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Trader's Corner

Another Tradable Bottom at Hand?

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I usually write this column on Thursday and did so last week, but a production glitch occurred that kept me out of the OI Daily Newsletter that day and I'm back with that article, but revised to today.

"TA" could stand for Teacher's Assistant, an element in the periodic table, Thermal Analysis, or the name of an investment group. TA is also an acronym for 'Technical Analysis'. As I sit here looking out over the beautiful blue Pacific Ocean, I am in my usual deep think about what I'm going to write about. As usual I will write about what technical analysis could be telling us about the current trend, along with notes on risk protection. When I don't hear from OI Subscribers suggesting their topics of interest, I rummage around in my own mind as to topics useful in trading options, what and why I got into past trades or, why not; e.g., why I stayed on the sidelines based on chart and indicator patterns. Also, very important, what mistakes I made (plenty) and what they taught me.

I can also report that I'm not IN a trade all that much, as I tend to wait for certain 'extremes' in the market. Extremes in price (e.g., waiting for a prior low or high to be re-tested);'oscillator' extremes (e.g., the RSI at 65-70 on the upside or 30-35 on the downside); extremes in 'sentiment' (i.e., traders get very bullish or bearish); some chart (price) 'patterns' you don't see all that much also reflect a type of extreme so to speak (e.g., a Head & Shoulder's Top/Bottom, a major double bottom or top, a 'rounding' bottom).

Besides trading LESS than many if not most, I mostly only BUY premium, although many good analysts and traders ONLY sell premium and think buying puts or calls is a losing strategy. One reason I do is my competitive nature. It's a heck of a challenge and thrill to accurately pick turning points in the market. My Wall Street/Trader mentor, Mark Weinstein (see the "Market Wizards" book), was an absolute master of knowing when the market was about to change direction.

Back to this question of BUYING options, versus selling premium; everything from selling puts, calls, and all the varieties of spreads and straddles, etc. Isn't buying a sucker's game so to speak? Don't most traders lose money that way? It's true many if not most holders of options lose money. However, I say the reason is NOT that, intrinsically, buying calls and puts is a losing proposition, but the reason is a failure of discipline and at least some dedicated work and study. It's a failure of WAITING for the right opportunity. Many great traders will tell you that they made more money waiting for the right conditions to pull the trade trigger than they did by frequency of trading.

People who advise being on only one side of the buying versus selling premium game are saying that they find the buying game a losing proposition for THEM. Is it more profitable to be in the market frequently, making steady perhaps modest money taking advantage of the relentless erosion of premium, or to be in the market only a few times a year, maybe only a couple times a month, for big 'scores' as my mentor used to say? Having been a stock and options broker once, I know for sure that you don't need to trade often (it paid me well!), only to trade well for yourself.

Timing is everything in terms of buying options. If you wait only for the relatively few times that the major indexes or key stocks are quite overbought or oversold, raising the probability for a trend reversal or a break out move, you will have more time on your hands to study market conditions. If you can't wait as you're addicted to action, know that this involves a greater degree of gambling. I rarely devoted full-time to trading but often was paid to comment on the market OR run a department; even then I consistently made time daily to update my charts and thinking on the market.

Buying options at extremes tends to also control risk and makes for a more favorable risk to reward. Extremes in the market are points where you can usually exit with a small loss if you are wrong; e.g., when an index or stock is extremely oversold does NOT tend to also be when the market tanks on negative news as all or most bearish influences have already been factored into current price levels. Markets tend to go from extreme to extreme.

You can use 'tight' stops/exit points only at extremes. Your 'reward' potential is greatest at the high potential points for reversals if you've gone against the trend-followers. The tendency for a 'trend-following' strategy and thinking is what makes 'contrary opinion' work. When all are bullish everyone is long and it's often time to exit. I'm going to pull much of the above 'theory' into illustrating some past and current trade 'set ups'.

Even in a market with a dominant and prolonged trend, there are nevertheless challenges in knowing where to take profits on an options position, then knowing when to get back in, especially when the trend turns mixed and volatility increases. Especially then I recommend close study of HOURLY charts and especially with the stock indexes, using 90-120 day or more of hourly history, which is why you usually need your own charting application with a good data base, whether history resides 'locally' on your machine or you pull in all price history from your provider's database.

I often say that the Dow 30 (INDU) is one major index that trades quite 'technically' much of the time. For example, INDU trends steadily lower along a well-defined down trendline as seen below. I also suggest use of the Relative Strength Index (RSI) with a 21 'length' setting, a fibonacci number; I use 13, a fib number, on daily charts.

In a downtrend, RSI extremes will be less frequent and won't tend to as high as 70. 30 and 70 are the most common 'default' settings for 'oversold' and 'overbought', but you should evaluate your own 'extremes' for any given market cycle. Readings at 65 and above have defined 'overbought' extremes in recent months on the 21-hour RSI. A clear cut put buying opportunity came in mid-May, when a double top and a 65 RSI extreme lined up, per the first set of red down arrows (left) below.

The oversold extreme in the INDU downtrend has been at the common 'default' setting at 30, as highlighted by the green UP arrows. Should puts have been exited at these points? Yes, as you don't know the strength of a counter-trend rebound. After the rebound at the first such extreme, there was not a second overbought 'extreme'. However, there was another TA pattern that suggested a next put buy.

An important technical concept is that of a chart 'breakdown' point, where prices have a DECISIVE downside penetration of a prior low. Expect a return to this breakdown point be a definite new resistance as seen at the second red down arrow on the hourly chart below. The return to a key breakdown point is also a type of 'extreme' and suggests a good opportunity in puts; with tight stops, it also offers a favorable risk to reward ratio; e.g., 1 to 3 or more.

Based on the MOST RECENT oversold RSI reading occurring TODAY, there is now a compelling reason to get out of puts based on the above hourly chart and indicator patterns. I also see a favorable risk to reward in buying S&P and Dow Index calls.

Shifting to the daily S&P 500 (SPX) chart and using the 13-day RSI as a trading input, today's second foray into the RSI oversold zone, is more compelling as a possible trading 'signal' because SPX held an important prior low. I would set my exit point on calls bought today to just under today's lows, which constitutes a 'tight' stop. Relative to this amount of risk, I assess upside potential as 3 times my exit point and the trade risk to reward potential I favor.

Trader sentiment as suggested by my 'CPRATIO' indicator seen next with the OEX daily chart, has been coming down steadily and got to the kind of extreme on Friday after which I then anticipate a good-sized rally to follow within 1-5 (trading) days of such a 1-day extreme, at the level green line highlighting an equities call to put reading of 1.1.

All prior extreme 1-day readings seen below at the green up arrows suggested rallies should develop. 'Too many' traders were in puts, short stocks or out for the market NOT to go the other way; i.e., UP! The market is perverse that way, but this dynamic reflects the fact that too many traders follow what others are doing rather than ANTICIPATE where/when the market would be primed to shift direction. The first 'CPRATIO' extreme was a shorter-lived rally, the second was a major rally, the third was a 'continuation' signal and the forth or last one has an unknown outcome.

It seems 'logical' that that when a key stock index such as the S&P 100 (OEX) is coming down to likely support, such as OEX 595-600, that traders might get MORE bullish and pick up their activity in calls, but they have been trading in the proverbial REAR-view mirror and looking at what came before and expecting the current trend to carry on!

For another view of the further downside potential in S&P puts, I'll shift to the hourly SPX chart for a closer up view in the S&P 500 (SPX) to compare to and with the SPX daily chart seen above.

Although there was no hourly RSI overbought extreme (at 65) that was seen, the double top in SPX (with the second top noted at the red down arrow), is the type of chart 'signal' that only comes along occasionally and is a pattern that suggests perhaps going into puts in a bigger way than just a typical trade as long as this is not an over-commitment of total trading money and with a tight overhead exit point/stop. This is where WAITING pays off. It would take a lot of trading to make as much as could have been achieved after the second tip off top.

The recent hourly RSI has finally 'signaled' an oversold condition. In order not to get too mesmerized by just the RSI, the price pattern is of primary importance. Today's rebound from the highlighted down trendline, intersecting around 1304, provides a favorable suggestion of a bottom. I don't think there's much downside left, but on call purchases would risk only to just under today's 1304 low or, at most, to just below 1300 through tomorrow (Wednesday) only.

I've noted a bunch of LETTERS at points on the hourly Nasdaq 100 (NDX) chart below where trade possibilities are suggested and their rationale technically.

Points 'A' and 'B' were both accompanied by RSI (overbought) extremes and buying puts at point A would have resulted in being stopped out if we went on the overbought extreme alone. There WAS a sharp but brief dip that followed. The rebound and climb back ABOVE point A would have been my exit point and the most I would have risked. The second top B constituted a favored trading set up where RSI failed to 'confirm' price action by its own higher high, which suggested that 'internal' relative strength was diminishing.

Point 'C' not only saw an oversold extreme but most importantly was a double bottom low. A major rally followed. Points D and E constituted the same type of trade set up suggested at point A and B. Point 'F' looked like a significant buy in the area of prior low 'C', but the well-defined although short-lived up trendline (after the low at F) got broken and was a clear cut warning to the bulls. When point F was pierced after that, it was time to exit if not done sooner.

The recent NDX top at 'G' formed an approximate double top in the 1987 area, but prices rebounded yet again after declining to 1940. That rally failed again in the same area forming a TRIPLE top. Puts bought in this area were quite profitable into today, with 1900 looking like a good place to exit. Just as important as the 'reward' potential, placement of a tight stop, just over recent highs, offered a low 'risk'. Relative to that exit point or risk, a sell off to the 1900 area (my target) offered good potential relative to the amount risked.

LAST BUT NOT LEAST, point "H" seen above was today's hourly low and along with it came an oversold 21-hour RSI reading, where previous buying opportunities have occurred. My chart analysis has suggested that the 1900 area ought to hold as a low with part of the reason being support implied by the circular arc bottom pattern I've highlighted on the NDX DAILY chart below.

While the NDX daily chart still suggests potential for prices to fall further and 'fill in' the chart gap on a decline to the 1850 area, I also see trade potential in buying NDX calls around 1900, risking only to 1885, knowing that I could end up with a small loss and re-evaluating calls later on, such as on a decline into the gap area.

Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with any questions or comments, with 'Leigh Stevens' in the Subject line and it will get forwarded to me for a reply.


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