Demark Indicators Explained

INDICATORS

Any system or set of indicators that can consistently identify low-risk trading opportunities that exist in the option markets will undoubtedly have a great impact upon the way options are viewed and traded. The most dramatic effect will be noted by the purchasers of options. Most traders are convinced the only way to make money trading options is to write options, not to purchase options. The biggest enemy of any trader who purchases an option is the time value of premium. It always appears that the premium’s time value decays far more quickly than the option buyer would like. And as option traders know, the option decays quickly when the market fails to move in-the-money in a relatively short period of time, either moving further and further out-of-the-money or remaining dormant for a long period of time.

However, if traders were to time their market entries and only take trades at those times in which the market was vulnerable to price reversals, they would be able to reduce the negative impact of time decay to a tolerable, possibly minimal, level. This is particularly the case if one is trading options intraday or trading an option with an expiration far into the future; in each of these cases, a few bars of adverse movement will not have a consequential effect upon the overall status of the option. In fact, purchasers of options may be able to make the time value work to their advantage rather than to the option writer’s favor. The primary reason is that the value of time is a somewhat arbitrary and subjective figure. If the underlying market were to experience a dramatic move, the time premium could conceivably experience a percentage increase that is exponentially greater than its initial value. Therefore, with effective market-timing techniques, time decay may in fact have no effect whatsoever and work on the side of the option holder as opposed to the option writer.

One of the biggest problems that the average trader has is timing his or her entry point. While traders may have opinions about a certain market or have heard a news announcement that influences them to enter a market, the question remains, when is the best time to enter? Even if one is able to select a day to enter, one must still pick the time of the day to enter. Most often, the average trader enters the market with a market order once he or she decides on a particular security, or the trader will pick an arbitrary price level at which to enter the market. These entry points may be fine, but there is usually no justification for or significance attached to the selection of these levels for one’s entry—they are simply arbitrary prices. In a sense, these individuals are trading blindly; and while this subjective buying and selling (or call and put buying) may work for a short period of time, eventually one’s luck will run out. By introducing indicators that can be applied effectively not only to daily price charts but to minute and hourly charts as well, such as TD Sequential and TD Combo, among others, traders can coordinate their buying or selling efforts with points of anticipated market strength or weakness. These indicators should greatly improve traders’ market-timing abilities not only in timing the purchase of securities but also related options, allowing the traders to control their risk more efficiently.

The market-timing techniques in the chapters that follow have been the culmination of approximately 30 years of work. Approximately half of the indicators that we discuss are new indicators, with some applying directly to the option contract, such as TD % F and TD Dollar-Weighted Options, and the rest applying to the underlying asset which can, in turn, be utilized to trade the related option. While you may recognize some of these indicators from some of our earlier work, the descriptions that follow will be different in that new aspects, new qualifiers, and new settings will be introduced and emphasized, often allowing one to trade the indicator results differently; these descriptions are presented with option trading in mind; and the indicators are described in a much simpler and less-intimidating manner than before.

Even though many of these indicators were created to identify potential reversal points in the underlying stock and commodities markets, the results can be utilized to perfect one’s entry in a security’s option as well. These techniques work on a variety of levels; consequently, not only will you be able to apply these indicators to trade in the traditional long-term manner we have described in our previously published books and articles, but you will also be able to use them on shorter time periods, providing an excellent opportunity to day trade options and the underlying assets. While we both strongly believe in the effectiveness of these indicators, it is important that traders apply these indicators in the proper context. For example, it is counterproductive to permit an option’s premium to erode, stubbornly holding a one-minute or a five-minute indicator-driven, low-risk trading position which fails to respond as expected. Also, just as option trading is not for everyone, neither is day trading. Of all investment strategies or stances one can take, day trading is definitely one of the most difficult to master. However, at the very least, these indicators, when applied on a short-term basis, should provide a trading edge in identifying reasonable entry points and exit points for the trader, so as to enable a trader to maximize profits.