Candlestick Charts - Option Trading

Candlestick Charts

At the beginning of this chapter, we said that Honma discovered that emotions play a significant part in the supply and demand for stock and therefore were important in determining price. In this example, all we know right now is that the market is bidding volatility to very high levels but that just means the market expects large price moves in the near future. We need to know if these large moves are due, for example, to an impending takeover (bullish) or corpo­rate scandal (bearish) that is about to hit the news. Let’s take a look at a candle­stick chart on VIP and see if we can get a sense of how the supply and demand is stacking up. Figure 16 shows a two-month candlestick chart right up to the December 16lh date of our decision:

At the right side of the chart, you’ll see the last two candles forming a classic “Bullish Engulfing” pattern. In fact, the second “engulfing” candle never traded below the opening price, as there is no lower shadow. This shows us that the traders are stacking up as net buyers and we should expect the stock to con­tinue higher. There is no way to get the information that quickly from a western style “open-high-low-close” chart. With one simple glance at a candlestick chart, we now know the two important pieces of information that are needed to trade options profitable - direction and speed. We know the market demand is stack­ing up to the bullish side and that volatility appeal's to be too high. So, what type of strategy should we use? Because the market is bullish, we do not want to be caught holding short calls since that is a bearish bet. If the market is correct, we could end up with huge losses even though we were correct in selling theoreti­cally high volatility. In order to create a winning trade, we need to take into account that we are bullish along with our belief that volatility is high. Because we’re bullish, we obviously want a bullish bet. But because volatility is high, we do not want to buy a bullish bet. Instead, we need to sell the bullish bet. And that means we need to sell puts.

Figure 17 is a reprint of Figure 1 and Figure 2. You can see that selling the $33,375 put for $3.40 would yield a nice profit after buying it back thirteen days later for only $1.65.

How would the other puts have performed? The $31,625 puts could have been sold for $2.40 and repurchased for $1.05 and the $35 puts could have been sold for $4.50 and repurchased for $2.45. The sale of any put resulted in a significant gain for the simple fact that this simple strategy properly aligned both the directional and volatility aspects of options.

As we stated before, the purchase of any call resulted in a loss. And that’s because the buyers were correct on direction (the stock did rise) but they were wrong about volatility (they bought the high volatility). Many traders believe that if calls are expensive to buy then they must be a great deal to sell. Let’s see if that’s true. Notice that if you had sold the $33,375 calls, you would have sold for $1.75 and repurchased for $2.25, which leaves you with a loss. By selling these calls, you were correct in selling volatility (you sold volatility when it was high) but you were wrong about the direction of the stock. In fact, the sale of any of the calls resulted in a loss. It is only the short put trader that made money since that strategy properly aligned direction and volatility. Only when both com­ponents are properly aligned can you expect to make money with options.

Once again, notice that the one-dimensional stock trader would have made money by purchasing at $31.41 and selling for $34. But in order to make money with options, you must be correct on direction and speed. And that means you must take volatility into account.

Your best source for understanding volatility comes from using the BlackScholes Model and the best directional indicators come from candlestick charts. It is the trader who uses both tools that will be able to separate price and value of options.