I use technical analysis. I also like studying the Greeks of the options. Sometimes when discussing options with those who manage trades by the Greeks, I sense a pause or hesitation when I mention some tenet of technical analysis. The unuttered sentence that fills that pause is something like this one, with an imagined curl of the lip as it is spoken: You use antiquated and useless technical analysis?
Of course I do. And so do those who manage by the Greeks. That includes me when I'm using that method for examining portfolio risk.
For example, many manage-by-the-Greeks pundits study the predicted standard deviation of the underlying. If, on July 3, I had been considering buying an XEO JUL 420 call, I'd want to know what my profit or loss might be at certain XEO levels. I'd also want to know how likely it is that the XEO would reach those levels. If I were a dreamer and hoped to make $4,000 profit on my position, I might use a standard deviation calculator to see how likely it would be that my profit would be more than $4,000 at JUL expiration, which occurred this weekend. Of course, no manage-by-the-Greek pundit is likely to employ a single long option position, but I want to demonstrate something about technical analysis rather than about complicated positions.
XEO 1- and 2-Standard Deviations Shown in Green, as of 4/3/09:
That imagined $4,000 profit didn't look too likely at the time, and it didn't turn out to be realized, either, of course.
Standard deviation calculations assume a normal distribution of prices, and that's not always the way prices are distributed. However, if we allow that assumption, the green one-standard deviation lines were marked just above 440 and just below 400. That means that about 68.2 percent of the time, the XEO would be expected to be at or between those two levels at expiration, which it was. About 95.4 percent of the time, the XEO would be at or inside the two outside vertical green lines. That hoped-for $4,000 profit seemed a dim possibility when the chart was snapped. Studying the standard deviation's predictions would have perhaps led me to look elsewhere if I were a swing trader hoping for a $4,000 profit between July 3 and expiration.
Looking at standard deviations is one way of determining where an underlying might go within a certain time period, and it's a valid way. It's a method chosen by many who manage by the Greeks and eschew normal price chart studies. These people may also use the delta of an option to determine how likely it is to be in the money at expiration. An option with a delta of 0.07 (or 7 after the 100 multiplier is applied) has only a 7 percent chance of being in the money at expiration. Traders who use either of these methods to determine where the underlying might be at expiration tend to declare that they don't use or believe in technical analysis.
However, those standard-deviation calculations are only one way of predicting possible price movement, and some other methods fall more squarely into the traditional technical analysis realm. The average true range indicator is another. Those subscribers who have read my commentary over the last years know that I like to study nested Keltner channels, configured in a way that I find useful to study. If I look at the XEO's nested Keltner channels as of July 3, the same day the standard-deviation chart was snapped, I found that those channels predicted that the XEO would most likely trade in a band from about 402.50-449.50. Those Keltner bands are dynamic and might be expected to change a bit with price movement.
XEO Daily Chart with Nested Keltner Channels, as of 7/3/09:
QuoteTracker Chart snapped 7/03, not current prices
The standard deviation calculations, favored by those who eschew technical analysis, points to a range of about 400-441 for the XEO, with about a 68.2 percent chance that it would stay in that range into expiration. The same day, another charting service, using this different study of nested Keltner channels, pointed to a range of about 403.50-449.50.
Are the two studies and two charting services so far off that we can say one is preferable to the other? Is one more trustworthy than the other? Does the use of one or the other render the user a savvier trader, more elite or erudite than the bumbling trader using the other study?
Of course not. Each such technical analysis tool offers insight into what might happen. In some cases, studies offer some perspective on how likely a certain event is. Some, such as chart formations, offer potential targets if certain conditions are met. Portfolios can be examined and decisions made about how high losses or gains might be if the indices were to move to certain levels or fulfill certain charting predictions. Decisions could be made.
Similarly, I can go to the "Greeks" tab on my brokerage's site. Peering at my portfolio's delta and vega, in particular, I can measure what my portfolio is expected to gain or lose for each point change in the underlying and percentage-point change in volatility. I can make decisions.
They're tools, that's all. Whether you call yourself a technical analyst or turn up your nose at the term, whether you shake your head in awe at those who understand something about the Greeks or feel intellectually inadequate when you learn of others setting up neural networks to aid in their trading, we're all just using tools to refine our techniques.
Whatever form of technical or "not" technical analysis you're employing, learn to use it well. This is the real point of the article. If you're a fan of CCI and RSI because these indicators tend to react quicker, sometimes predicting rather than reacting to price movement, you'd better know that there's a tradeoff: they can give more false signals than slower indicators. If you're a fan of moving-average crossovers, know that they tend to signal well after a move is underway. If you're a fan of nested Keltner channels, know that these dynamic channels can tend to get pushed a bit in the direction of the move, so that resistance in a rising market also rises and support in a falling market also falls. If you're a fan of calculated standard deviations, you'd better know that rising volatilities widen those standard deviations.
No sneering allowed. We're all technical analysts. We just use different tools.