Pulling It All Together

PULLING IT ALL TOGETHER

Now that we have described how these indicators identify low-risk price reversals on a long-term and a short-term basis, let’s combine these various techniques into a seamless trading methodology.

The pace of life has accelerated in recent years but it pales when compared to how conditions have changed within markets around the world over the past 25 years. Barely a generation ago, the volume on the New York Stock Exchange averaged 6 million shares a day. We recall in the summer of 1973 when the market closed early just to handle the additional paperwork associated with the increase in volume of a mere 1 to 2 million shares a day. Daily moves in the Dow Jones Industrial Average of 20 to 30 points were rare and whenever weekly declines exceeded 50 points, portfolio managers were frozen and quick to anticipate a replay of 1929 or some other serious market calamity. To prevent similar financial disasters, most market officials were reluctant to introduce new products and relied upon legislation introduced since the Depression of the 1930s to protect the economy.

The introduction of capitalism and markets worldwide, as well as the acceptance of derivative markets by conservative trust departments, endowments, pension accounts, and government agencies has been an encouragement to investment pioneers to experiment and expand trading opportunities and horizons. The growth of the various trading vehicles and the acceptance and appetite of the trading community for these products have been astonishing. Despite this incredible growth, one factor has remained constant and that is the psychology of those individuals who trade these various markets. The same emotions which drove the individual trader to make certain decisions in the stock market throughout the years still affect those who trade the commodities, financial futures, equity, and options markets today, but now they may be more exaggerated due to the leverage involved in these markets. Often the tools used to evaluate these markets have been developed by professors and market research quantitative think tanks. Their techniques to calculate realistic price valuations are a testimony to the importance of technical market models, as well as the acceptance of this sort of methodology.

Despite the widespread interest in these new markets, there is one aspect which has lagged in this rapid growth, and that is data reporting and availability. Although the overall data-reporting process has improved tremendously since the days of old, there are still many pockets where the process is lacking. In fact, the effort to write this book illustrates this one deficiency loud and clear. Whereas we have made numerous observations regarding option day trading throughout the years, many difficulties arose when we attempted to document and test them. Unfortunately, there are only a few providers of stock and commodity option data and those who do provide them do not necessarily provide the same information. The information lacks both consistency and accuracy. In addition, due to the enormous amount of data, as well as the frequency of price errors, extensive work is required by these providers not only in data storage and management, but also in data cleansing. While one data vendor may provide daily option high, low, and closing bid and ask and no close, another may provide open, high, low, and close; the one or two other stock option providers will merely report the close and perhaps only report the statistics for the nearby option expiration and strike price. Surprisingly, even the exchanges fail to make available the data. As far as futures option providers, the problems are no less serious. There are few data sources and those who do supply option data to the public are at the mercy of the various exchanges who do not necessarily correct bad data reports.

Now if one were to overlook the occasional bad data, testing of the various option trading techniques could be done. We conducted some of our own indicator testing but became exceedingly frustrated. In fact, to illustrate examples of TD Dollar-Weighted Put-Call on an intraday basis is futile, let alone impossible. To do so, one must obtain accurate indications of trading volume and price activity which occurs at specific times during the trading day—in other words, one requires data that one just can’t obtain. To illustrate examples hypothetically based on market tendencies that we have seen is much more realistic and sensible. This concern applies equally, only to a lesser extent, to TD % F, since we found the daily highs and lows are sometimes reported incorrectly. Nevertheless, we believe the concept of TD % F is most critical and can be tested by following the option markets real time and paper trading the indicator. And, with additional experimentation with this option market-timing technique in real-time scenarios, a trader can further enhance both its performance and its utility. The critical factor is to open one’s mind to these methods designed to assist option traders.

A TRADING GAME PLAN

There are many considerations that must be brought together in order to determine the best way to trade options. Following the markets throughout the years has enabled us to make numerous observations concerning the trading activity of underlying securities as well as their related option markets. While we do not proclaim to be experts in the ways of option trading, there are certain items that we look for before we will trade a particular option market. Our plan of attack is not necessarily correct but it is mechanized, enabling us to participate in a variety of markets with consistent results.

When evaluating and arriving at an ideal low-risk entry price level, the relationship between the option and the underlying security must be in synchronization. Despite the fact that the option markets are mature exchanges, it does not alter the fact that trading volume may be light or even non-existent in a particular option. When a small group of large individual traders or a large group of small traders have an interest in a market, liquidity exists; without this feature, trading is erratic and unpredictable. That is why it is important that, before traders even consider trading an option, they compare the underlying security to the respective option to determine how the two instruments move together and whether the market can be traded effectively. It may just so happen that the option activity is so slow that the contract hasn’t been traded for hours, or even days, meaning any trade that occurred would require the trader to make considerable price concessions. If a market is inactive, most often it is best to avoid day trading in that option altogether. Consequently, make certain that the option is liquid and that any comparisons to be made between an option and its underlying asset are based upon trades which occur within the same time frame. By comparing the two when an option has not traded for a period of days and the underlying security has traded consistently produces a distortion in comparative results. Furthermore, one must be wary when comparing the closes of the option and the underlying security, for the underlying may have traded consistently into the close while the option may have gone hours without trading. In addition, the fact that the underlying security opens prior to the options anywhere from one to several minutes later can also give a misrepresentation to any comparisons which may be made. Just to be safe in these scenarios, always note the time of each security’s last trade.

We prefer to select our option trading opportunities from those options which are close to expiration and trading at- or slightly in-the-money in order to eliminate as much of the time value from the premium as possible. This way, we are essentially trading an option’s intrinsic value and are unaffected by some of the negative impact of time decay. Generally, we like to concentrate upon those options which are within two to three weeks of expiration. Before we enter into any option position, careful consideration is always given as to our level of exposure. We feel that it is important for traders to avoid overextending their capital commitments in any one market, as any adverse price movement or lack thereof will have a deleterious effect on their option positions. Therefore, when day trading, we typically limit our option purchases to a fraction of what we Would pay to own the security outright. We tend to go with exposure percentages of 2 percent of our total portfolio value for day trading options, and 4 percent for position trading options. As with long-term investing, one should always look to spread risk across a variety of investments and diversify one’s portfolio. Our intentions in presenting these percentages are not to determine the exact number of option contracts we feel a trader should buy based upon a mathematical formula—after all, each trader is different—rather it is to ensure that traders are cognizant of the risks inherent in option trading. To find success in option day trading and position trading, timing is the key, not size. Also, we always trade out of our option positions, rather than exercise them—after all, who’s ever heard of a successful option day exerciser? By trading out of our position, we save on commission costs, we don’t lose the option premium, and we receive the intrinsic value of the option as well as the additional time value, thereby maximizing our potential profits.

We also make several considerations as to when we should purchase our options. It is also important to consider the day of the week in which one should enter the option market. Specifically, one should be wary of holding positions from Friday to the following Monday, as many option theoreticians recalculate their volatility and delta numbers once a week to determine an appropriate value for the time premium, usually after the close of trading on Fridays or over the weekend. This can have a negative impact upon the price of one’s long option position, particularly as the option approaches expiration. It is also wise to avoid purchasing call options just prior to a stock going ex-dividend. Because call options do not entitle the holder to any cash dividends, the value of one’s call option will decline upon the ex-dividend date. It is important that a trader be aware of the ex-dividend date prior to initiating a long call position. Additionally, since most of our indicators dictate that the timing for option entry depends upon the price activity of the underlying security, the exact time of entry is unpredictable, but when day trading we look for and select option trades whose low-risk call-buying or put-buying opportunities occur earlier in the trading day. These trades will give the market adequate time to develop and perform. We also avoid purchasing options after a trend has been established, particularly when day trading, as trend followers miss out on the initial expansion in call premiums following a price low and put premiums following a price high. We prefer to utilize market-timing indicators to anticipate intraday price reversals and maximize our option profits.

Most of the market-timing techniques we describe can be applied to the options themselves as well as to the underlying securities. Since the data is more readily available for the underlying securities and this information includes corrections, we suggest applying the techniques to the underlying securities as a proxy for the options. We presented a number of techniques which enable a trader to enter a market at the open of trading, at the close of trading, or at any point in between. If one were a day trader, obviously, the thought of entering a trade at the open and the potential of exiting any time during the trading day is most appealing since it maximizes the game clock to its absolute limit. Not only are the specific entry techniques we suggest critical, but so are the various methods we present for exiting the market other than the old day trading stand-by: on the close.

Our intent is to introduce you to an assortment of various market-timing techniques, and we encourage you to apply them to both the option—provided you have confidence in your data—as well as the underlying security, and then trade the option intraday with a profit objective in mind. Since we are suggesting one utilize these indicators on such a short time frame, gains may be small relative to the profits that can be expected over greater time frames. To account for this, we suggest that, if possible, traders have larger stakes in some option markets in order to make these trades worthwhile, particularly if the options are relatively inexpensive. Our work does not preclude a trader from extending the trade past the boundaries of that specific trading day or even trading in the underlying security itself. The “options” available to the trader are manifold.

Alignment is a practice we like to apply to our trades. Alignment relates to the juxtaposition of an indicator over a series of time periods. Ideally, we like to see each indicator confirm a low-risk trading opportunity on several different levels. Specifically, if the overall market environment is conducive to a trend change, we want to be there as soon as we can, meaning finding the point of inflection on the smallest time frame possible. For example, it would be appropriate for a daily, hourly, or 30-minute chart to be consistent with the direction in which a one- minute trade is about to be elicited. Typically, we start our indicator search on greater time frames to establish the overall trading environment. To day trade, we then move to smaller and smaller time periods in search of shorter-term indications which confirm these results (although we will occasionally take low-risk call buying or put-buying indications that go against the bigger picture every now and then). Once our entry point has occurred, we then repeat the process to locate an ideal low-risk exit point. We’re not implying that this process of confirmation be as stringent and complex as unlocking a safe, but we are emphasizing the fact that a confirming, overriding indicator will enhance the prospects for trading success.

In addition to alignment, we also like to confirm one indicator with another or a series of others. This is an extremely important requirement that we make for ourselves when trading. There is a distinct comfort level when numerous indicators all confirm an impending trend reversal. However, as is the case with alignment, it is important that traders not overextend themselves in terms of adding too many variables to their trading decisions, as these could conflict with one another, leaving the traders indecisive as to what the next move should be. Oftentimes, when too many indicators are applied to a market, with some conflicting with others, market readings become overloaded. Therefore, to combat the possibility of conflicting indicator readings, we suggest that traders determine which indicators establish precedence and take priority over others, and use those to overcome any uncertainty.

We are very mechanical in our approach to trading. Whether we intend to trade options or their underlying securities, we examine markets with an indicator checklist, noting which market-timing techniques are speaking for which markets. Once we obtain a general picture of the market, we can make our option trades and our security trades accordingly. The following paragraphs include some of the most important indicators we use when loading our trading shopping cart. While we will include some of the basic option strategies we would use in the event of a low-risk entry or exit, traders can substitute any other strategy they deem appropriate. This includes the strategies outlined in Chap. 2 and those which we were unable to address, but are heavily documented in other option literature, such as covered call-writing and covered put-writing strategies, butterfly spreads, ratio strategies, and synthetic trading.*

Option Buying Rules. We recommend before a trader purchases an option, be it a call or a put, that the market has fulfilled as many of the four option buying rules as possible. These rules are extremely important when applied to day trading.

·       Rule no. 1: Buy calls when the overall market is down; buy puts when the overall market is up. To determine whether the overall market is up or down, we examine the advance/decline index, or a comprehensive market average such as the S&P 500 or the New York Stock Exchange Composite. When the overall market trades lower, call option premiums typically decrease. Therefore, by requiring the market index to be down for the day at the time a call is purchased, the prospects for a decline in a call’s premium are enhanced. Similarly, when the overall market trades higher, put option premiums typically decrease. Therefore, by requiring the advance/decline market index to be up for the day at the time a put is purchased, the prospects for a decline in a put’s premium are enhanced similarly.

·       Rule no. 2: Buy calls when the industry group is down; buy puts when the industry group is up. Just as most stocks move in phase with the market, so too do most industry group components move together with their industry counterparts. When one stock within an industry group is down, chances are the others are down as well.

·       Rule no. 3: Buy calls when the underlying security is down; buy puts when the underlying security is up. In order to time the purchase of calls, we look for the price of the underlying security to be down relative to the previous trading day’s close, as most traders believe this implies that the down trend will continue. To make this rule more strict, we will also relate the stock’s current price with its opening price level. Either comparison ensures that the market’s outlook is perceived bearish by most traders. In order to time the purchase of puts, we look for the price of the underlying security to be up relative to the previous trading day’s close, as most traders believe this implies that the up trend will continue. To make this rule more strict, we will also relate the stock’s current price with its opening price level. Either comparison ensures that the market’s outlook is perceived bullish by most traders.

·       Rule no. 4: Buy calls when the option is down; buy puts when the option is down. The option’s price, be it a call or a put, must be less than the previous day’s close. As an additional requirement, it may also be less than the current day’s opening price level as well. Of all rules listed, this requirement is singularly the most important.

The combination of the preceding rules removes one’s emotions when trading options to make the process of option buying more mechanical and objective. Occasionally, we will make these trading rules more stringent by comparing the current trading bar’s close to the current trading bar’s open, as well as the current trading day’s close to the prior trading day’s close.

TD % F. The first indicator we rely upon when trading options is TD % F. We feel this is one of the simplest and most effective option trading indicators to use when day trading options. What we are looking for with TD % F is for a current day’s call or put option to decrease to approximately no less than half of the prior trading day’s value, as calculated from the previous day’s close. When a call option’s current price declines to 48 to 55 percent of the previous trading day’s call option closing price level, we obtain a low-risk call-buying zone for the following trading day. Similarly, when a put option’s current price declines to 48 to 55 percent of the previous trading day’s put option closing price level, we obtain a low-risk put-buying zone for the following trading day. Our exit point is determined by our expectations for the option and the underlying market. If we are uncertain as to what the underlying security will do over the course of the day, we will use the profit-targeting low-risk exit levels that are calculated by multiplying the previous day’s close by 190 and 204 percent. On the other hand, if we believe that the market will continue to move in the direction that is favorable to our option position, be it a put or a call, and can exceed 208 percent of the prior trading day’s close, indicating that additional upside price movement should occur, then we may elect to maintain our position longer than intended without a profit target. In these cases, we look to the other indicators which can be applied intraday to indicate a possible price reversal and the need to exit our position, such as TD Sequential, TD Combo, and TDST. -Our stop loss levels are determined by how much we paid for the options. If the options are cheap, and we have not acquired too large of a position, we will not include a stop loss level—our long option contracts act as an inherent stop. However, if the option contracts are expensive, or if our option position is large, then we will consider exiting our position if the market trades less than between 42 and 48 percent of the prior trading day’s close, as additional downside price movement should occur. If one is uncertain as to whether a TD % F reading will hold, a trader could always trade a long call spread or a long put spread.

TD Dollar-Weighted Options. We also apply TD Dollar-Weighted Options analysis to the options themselves to arrive at a measure of market sentiment. TD Dollar- Weighted Options analysis differs from, and addresses the shortcomings of, the traditional method of calculating put/call ratios, where the volume of puts is simply divided by the volume of calls. We apply this indicator on a daily basis and on an intraday basis and then coordinate our option purchases at some point during the trading day with our other indicators as well. This sentiment indicator first measures the dollar value of the nearest expiration and strike options, by multiplying the call volume by the call price and by multiplying the put volume by the put price, and then divides the put activity by the call activity. When the dollar-weighted put volume exceeds the dollar-weighted call volume, by recording a put/call ratio of 2.00 or greater on an intraday basis, or 1.25 or greater on a daily basis, then the call option becomes more attractive and a low-risk call-buying opportunity presents itself. When the dollar-weighted call volume exceeds the dollar-weighted put volume, by recording a put/call ratio of 0.50 or less on an intraday basis, or 0.75 or less on a daily basis, then the put becomes more attractive and a low-risk put-buying opportunity presents itself. These readings identify the trend of the overall market environment.

A more comprehensive view of the market’s condition can be obtained by performing a more thorough put/call comparison by also using open interest. We first calculate the dollar-weighted put/open interest ratio by dividing the put volume by the put open interest, and then multiplying this ratio by the put’s market price; similarly, we calculate the dollar-weighted call/open interest ratio by dividing the call volume by the call open interest, and then multiplying this ratio by the call’s market price. Once these final dollar-weighted volume/open interest values are determined, the put value is divided by the call value to indicate the overall market environment. When the dollar-weighted put volume as a percentage of open interest exceeds the dollar-weighted call volume as a percentage of open interest, by recording a put/call ratio of 2.00 or greater on an intraday basis, or 1.20 or greater on a daily basis, then the call option becomes more attractive and a low-risk call buying opportunity presents itself. When the dollar-weighted call volume as a percentage of open interest exceeds the dollar-weighted put volume as a percentage of open interest, by recording a put/call ratio of 0.50 or less on an intraday basis, or 0.80 or less on a daily basis, then the put becomes more attractive and a low-risk put-buying opportunity presents itself. These readings identify the trend of the overall market environment.

If this fraction on an intraday basis is greater than or equal to 2.00, meaning the put volume as a percentage of open interest is at least two times larger than the call volume as a percentage of open interest, then traders are more bearish than bullish, and the market should rally—this occurs for the same reasons we mentioned earlier, specifically, because traders aren’t expecting the market to move higher and their selling campaigns are close to exhaustion. On the other hand, if this fraction on an intraday basis is less than or equal to 0.50, meaning the call volume as a percentage of open interest is at least two times larger than the put volume as a percentage of open interest, then traders are more bullish than bearish, and the market should decline—this occurs for the same reasons we mentioned earlier, specifically, because traders aren’t expecting the market to move lower and their buying campaigns are close to exhaustion. These ratios can be reduced to 1.20 for put options and 0.80 for call options when making a dollar-weighted put/call comparison as a percentage of open interest, on a daily basis.

In either instance, a dollar-weighted put/call ratio or a dollar-weighted put/call ratio as a percentage of open interest do not provide a definitive entry point, per se. Therefore, we typically apply the indicator on a daily basis and an intraday basis and then await another daily or intraday indicator to confirm the reading, such as TD % F, TD Lines, or any of the other indicators presented throughout the book. This process is what identifies a specific entry point for our option purchase. With TD Dollar-Weighted Options, our exit point is usually obtained when a short-term, intraday indicator reading in the opposite direction is recorded, usually TD Sequential, TD Combo, and TDST. Our stop loss level is either nothing at all in cases where the options are cheap or we don’t have a large position, or simply a dollar loss in cases where the options are expensive or we have a large position. Long spread positions can also be taken in the event of market uncertainty to reduce the cost of the option debit.

TD Sequential and TD Combo. Trading with TD Sequential and TD Combo on an underlying security provides us with much trading versatility and freedom. Throughout the trading day, a large number of TD Sequential and TD Combo trades surface across various time frames, enabling a trader to select from numerous possibilities. Because there are so many trading opportunities, we limit our low-risk trading choices to a small set of time frames (such as 1-, 5-, 10-, 15-, 30-, and 60-minute charts) to ensure that we are trading responsibly, not just actively. We can trade based upon a daily low-risk trading opportunity, and then time our entry intraday; or we can simply trade intraday based upon any of our   preferred time periods. Whether we decide to trade merely a completed Setup series or a completed Countdown series depends upon the indicator’s interaction with other indicators, such as TDST lines and TD REI with TD POQ. In either case, a low-risk put-buying opportunity would occur following the completion of a sell Countdown phase, and a subsequent entry indication if we were trading conservatively, for TD Combo and for either of the two possible TD Sequential settings; and a low-risk call-buying opportunity would occur following the completion of a buy Countdown phase, and a subsequent entry indication if we were trading conservatively, for TD Combo and for either of the two possible TD Sequential settings. If we were trading more aggressively, we could bypass the entry techniques and trade the options based simply upon the completion of the Countdown phase.

A similar trading situation occurs for completed Setups, particularly when a Setup is unable to exceed the previous TDST in the opposite direction, indicating the market may not run to the completion of the Countdown phase. A low-risk put- buying opportunity would occur following the completion of a sell Setup phase and a low-risk call-buying opportunity would occur following the completion of a buy Setup phase, provided each Setup fails to exceed the prior TDST line in the opposite direction. Because completed Setups and Countdowns can be quite powerful indicators, we would only trade low-risk trading opportunities with call and put options to ensure that our maximum gains are unlimited. We wouldn’t trade these readings with spread orders because they would limit our gains. When trading intraday, our exit point is obtained once a profit objective is reached or when a Setup or a Countdown has been, or is just about to be, completed on either the same or a different time frame. Our decision depends on our trading bias at that time. Our stop loss during these day trading sessions are, again, nothing in cases where our options are cheap or we have a small option position, and usually just a dollar loss if the options are expensive or our position is large.

The greater the time frame in which a low-risk TD Sequential or TD Combo Countdown buying (call-buying) or selling (put-buying) indication occurs for the underlying security, the greater the likelihood we will extend the holding period of our trade. As a rule of thumb, any completed low-risk TD Sequential Countdown or TD Combo Countdown indication occurring on a 30-minute basis or greater suggests that price will sustain an extended price reversal, over a number of price bars. Because these larger time frame indications typically last longer than shorter- term indications, with any longer-term intraday trade that we initiate, we will always evaluate our position prior to the close to determine whether we feel the market will continue its price movement prior to a price reversal, in which case we would hold our option position for at least one additional trading day.

Depending upon the situation, we may also trade options using any of the four indicators which can be used to initiate entry into a trade following a completed Countdown phase, specifically TD Open, TD Trap, TD CLOP, TD CLOPWIN (see Chap. 6). In these cases, we would use the indicators on a daily price chart and time our option purchases once the indicator rules are fulfilled. Unlike many of the other indicators, option entry for these four market-timing techniques can only occur intraday. We would look to buy calls when the market fulfilled the requirements for a low-risk buy opportunity and to buy puts when the market fulfilled the requirements for a low-risk sell opportunity. Our exit point is obtained when our profit objective is reached or when an indicator reading in the opposite direction has occurred. Our stop loss during these day trading sessions are nothing in cases where our options are cheap or we have a small option position, and usually just a dollar loss if the options are expensive or our position is large.

TDST, TD Lines, TD Retracements. Each of these three indicators identify breakout levels for the underlying security that can be traded as a trend-following technique or faded in cases where the levels are either disqualified (in the case of TD Lines and TD Retracements) or were not held on a closing basis, an opening basis, and then trade at least one tick beyond that level. We typically utilize these indicators on a daily chart and use their daily levels as low-risk intraday entry points, but they can be applied to intraday charts with effectiveness. As the time frame to which these indicators apply becomes smaller and smaller, we pay more and more attention to the qualified breakouts, as opposed to the disqualified breakouts (which are more important on a daily scale). If the market exceeds a buy TDST, a qualified TD Supply Line, or a qualified TD Retracement level upside, on a closing basis, the next bar’s opening price, and then trades at least one tick higher than the opening, then a low-risk call-buying opportunity is presented—although, we personally don’t often participate in these trend-following moves. If the market exceeds a sell TDST, a qualified TD Demand Line, or a qualified TD Retracement level downside, on a closing basis, the next bar’s opening price, and then trades at least one tick lower than the opening, then a low-risk put-buying opportunity is presented—again, we personally don’t participate in these trend-following moves very often.

If the market holds a buy TDST on a closing basis as well as the following trading bar’s opening, or exceeds a disqualified TD Supply Line or TD Retracement level upside (meaning none of the four qualifiers are met), then a low-risk put-buying opportunity is presented—on a daily chart, these are the type of option buying indications we are seeking. If the market holds a sell TDST on a closing basis as well as on the following trading bar’s opening, or exceeds a disqualified TD Demand Line or TD Retracement level downside (meaning none of the four qualifiers are met), then a low-risk call-buying opportunity is presented—again, on a daily chart, these are the type of option buying indications we are seeking. A trader could also enact a long spread to reduce the debit if one were so inclined, but that is up to the discretion of the individual. Because there is no definitive exit point aside from the closing price (unless other indicators insinuate that it would be desirable to extend the holding period of the option beyond the current day’s close), we utilize other indicators, including TD Sequential and TD Combo, to confirm a low-risk exiting point. Yet again, the stop loss level is arbitrary, depending upon the investor. For us, our stop loss during these day trading sessions is non-existent in cases where our options are not expensive or we have small positions, or is a dollar-stop if the options are costly or our position is large.

TD Line Gap and TD Line Gap REBO. These two indicators work much like typical TD Lines, only without the necessity of qualifiers. TD Line Gap and TD Line Gap REBO are indicators that construct TD Lines from a TD Point to a subsequent price gap or price lap. An upward-sloping TD Line Gap line connects the most recent TD Point Low to the low of the most recent price gap or price lap upside; conversely, a downward-sloping TD Line Gap line connects the most recent TD Point High to the high of the most recent price gap or price lap downside. Once a TD Line Gap upside breakout occurs above a downward-sloping line, a low-risk call-buying opportunity is presented. The only qualifier states that the current price bar’s opening price must open in the direction of the breakout, meaning it must be greater than the previous price bar’s close. Conversely, once a TD Line Gap downside breakout occurs below an upward-sloping line, a low-risk put- buying opportunity is presented. The only qualifier states that the current price bar’s opening price must open in the direction of the breakout, meaning it must be less than the previous price bar’s close:

TD Line Gap REBO takes things a step further to confirm TD Line Gap breakouts. TD REBO works by taking the price range of the prior trading day and multiplying it by a percentage—such as 38.2 percent—this value is then added to and subtracted from the current day’s opening price. In the case of an upside breakout indicating a low-risk call-buying opportunity, price must breakout above both the downward-sloping TD Line Gap line as well as the upper TD REBO level. The low-risk, trend-following entry point would occur at the higher of the two levels. Additionally, traders could also choose to enter at both price levels, purchasing a portion of their call positions at the first breakout level and the balance of the call position at the second breakout level.

We typically use TD Line Gap and TD Line Gap REBO on a daily basis. The most obvious reason is that intraday charts do not leave many price gaps. Unless a market is illiquid, where the spread between the bids and offers is wide, intraday price activity moves consistently without many price holes. They can be applied intraday on a larger scale, but these instances are typically used with any resulting price laps as opposed to price gaps. Therefore, we use the daily momentum levels of these two indicators as our intraday entry points. For both of these indicators, our exit point occurs when our profit objective is attained or when we receive a conflicting reading from a different indicator. If our position is large, our stop loss is placed at a level that corresponds with the most we would care to lose on the trade.

TD REI and TD POQ. We utilize TD REI and TD POQ together and predominantly on a daily basis or a longer-term intraday basis in the underlying security. If the TD REI records an extreme oversold reading, meaning the TD REI has resided below -45 on the TD REI oscillator for a period of six or more trading bars, then price should continue to decline; a trend follower could use this opportunity to purchase put options. Similarly, if the TD REI records an extreme overbought reading, meaning the TD REI has resided above 45 on the TD REI oscillator for a period of six or more trading bars, then price should continue to advance; a trend follower could use this opportunity to purchase call options. If the TD REI records a mild oversold reading, meaning the TD REI has resided below -45 on the TD REI oscillator for a period of five or fewer trading bars, then TD POQ can be applied. If in die underlying security, before an overbought reading is registered, the market records an up close that is followed by an opening price that is less than the up close bar’s high, and then trades at least one tick higher, then a low-risk trend-following call-buying opportunity is presented at the breakout price above the high. If the open is above the up close day’s high, but not above the high two price bars ago, and the close is above the open, then a weaker, but nevertheless low-risk, call-buying entry is indicated upon the close. If the TD REI records a mild overbought reading, meaning the TD REI has resided above 45 on the TD REI oscillator for a period of 5 or fewer trading bars, then TD POQ can be applied. If in the underlying security, before an oversold reading is registered, the market records a down close that is followed by an opening price that is greater than the down close bar’s low, and then trades at least one tick lower, then a low-risk trend-following put-buying opportunity is presented at the breakout price below the low. If the open is below the down close day’s low, but not below the low two price bars earlier, and the close is below the open, then a weaker, but nevertheless low-risk, put-buying entry is indicated upon the close.

We prefer to day trade disqualified TD REI and TD POQ oscillator readings, although both qualified and disqualified indications can be equally powerful. The only problem exists with the fact that a qualified TD REI indication is a trend following trade and therefore the option’s premium will already reflect some of the market’s psychology before one even enters the trade. For a disqualified TD REI and TD POQ indicator reading following a current mild oversold reading and an up close, TD POQ requires that the open of the price bar of the underlying security after the up close be above both of the two previous price bar highs in order to warrant a put-buying opportunity. In these instances, the opening price has been exaggerated upside and the market will typically decline, most often filling in downside any price gaps. For a disqualified TD REI and TD POQ indicator reading following a current mild overbought reading and a down close, TD POQ requires that the open of the price bar of the underlying security after the down close be below both of the two previous price bar lows in order to warrant a tail-buying opportunity. In these instances, the opening price has been exaggerated downside and the market will typically advance, most often filling in any upside price gaps. These trades can be entered intraday following the current bar’s opening price which indicates whether the trade will be disqualified and require a trader to fade the indicator or whether the trade will be qualified and require that the trader follow the trend of the market.

Our exit point for qualified or disqualified, extreme or mild readings is usually obtained when a short-term, intraday indicator reading in the opposite direction is recorded, usually TD Sequential, TD Combo, and TDST. You can see the importance of indicator alignment with one another. Our stop loss level is either nothing at all in cases where the options are cheap or we don’t have a large position, or simply a dollar loss in cases where the options are expensive or we have a large position. Long spread positions, similar to those mentioned in Chap. 2, can also be taken in the event of market uncertainty to reduce the cost of the option debit. In addition, option positions can be extended beyond the current trading day if other indicators support that action.

TD Fib Range, TD Exit One, TD REBO Reverse, TD Camouflage. Each of these four indicators are applied to daily price charts or long-term intraday charts of the underlying asset to arrive at a trading outlook for the option. Qualifiers can be introduced to each market-timing technique to enhance its results, but for the sake of simplicity, we’ll just present the indicator in its most basic form. TD Fib Range states that daily price range movements of 1.618 times the previous trading day’s true price range or 1.618 times the average of the previous three days’ true price range, when added to or subtracted from the previous trading day’s close, oftentimes corresponds with market exhaustion. When the market closes outside these points of exhaustion, an ideal low-risk call-buying opportunity in the case of a price decline below the lower TD Fib level, or an ideal low-risk put-buying opportunity in the case of a price advance above the upper TD Fib level, is presented at the close of the price bar or the following price bar’s open. We prefer to use this indicator together with TD % F and TD Dollar-Weighted Options, as they work well in conjunction with one another.

In the case of a TD Exit One low-risk call-buying opportunity, the market must first record three consecutive down close days, and then the current day’s open must be greater than the close one day ago and the current day’s low must trade less than the close one day ago. In addition, the price range one day ago must be greater than the true price range two days ago. The low-risk call-buying opportunity occurs one tick less than the close one day ago, or at the low one day ago, depending upon whether TD Differential says the underlying market should move lower or not: if the difference between the close one day ago and the low one day ago is greater than the difference between the close two days ago and the low two days ago, then the low-risk call-buying level is one tick below the previous day’s close; and if the difference between the close one day ago and the low one day ago is less than the difference between the close two days ago and the low two days ago, then the low-risk call-buying level is one tick below the previous day’s low. If price should rally after trading one tick below the prior day’s close, then we will purchase our call option position at that point; however, if price should rally after trading to the prior day’s low, then we will purchase a portion of our intended call position at the prior day’s close and the balance at the prior day’s low. The low-risk put-buying opportunity occurs one tick greater than the close one day ago, or at the high one day ago, depending upon whether TD Differential says the underlying market should move higher or not: if the difference between the close one day ago and the high one day ago is greater than the difference between the close two days ago and the high two days ago, then the low-risk put-buying level is one tick above the previous day’s close; and if the difference between the close one day ago and the high one day ago is less than the difference between the close two days ago and the high two days ago, then the low-risk put-buying level is one tick above the previous day’s high. If price should decline after trading one tick above the prior day’s close, then we will purchase our put option position at that point; however, if price should decline after trading to the prior day’s high, then we will purchase a portion of our intended call position at the prior day’s close and the balance at the prior day’s high.

TD REBO is a momentum indicator that measures the previous trading day’s true price range, multiplies this value by either 38.2 or 61.8 percent (or any other percentage with a reliable history of effectiveness) and then either adds this value to or subtracts it from the current day’s opening price     to establish a low-risk option entry. If the underlying asset’s price trades above the upper TD REBO level, then a low-risk (trend-following) call-buying opportunity exists at that price level; if the underlying asset’s price trades below the lower TD REBO level, then a low-risk (trend-following) put-buying opportunity presents itself. TD REBO Reverse, on the other hand, is trend anticipatory. In the case of a low-risk call-buying entry, if the current day’s open is above the previous three days’ closes and the entry price is above the prior three days’ highs, then buying at a price level which is calculated by multiplying the greater of the two previous trading days’ true ranges by a percentage—such as 61.8 or 38.2 percent—and adding that value to the current day’s open would be too aggressive, and rather than purchase a call upon the TD Reverse REBO breakout, we would purchase a call. In other words, if the current bar opens greater than the close of each of the three prior days, and the entry price is greater than the high of each of the three prior days, then one would fade the perceived REBO upside breakout. Conversely, in the case of a low-risk put-buying entry, if the current day’s open is below the previous three days’ closes and the entry price is below the prior three days’ lows, then buying at a price level which is calculated by multiplying the greater of the two previous trading days’ true ranges by a percentage—such as 61.8 or 38.2 percent—and subtracting that value from the current day’s open would be too aggressive, and rather than buying a put upon the TD Reverse REBO breakout, we would purchase a call. In other words, if the current bar opens less than the close of each of the three prior days, and the entry price is less than the low of each of the three prior days, then one would fade the perceived REBO downside breakout.

TD Camouflage is used on larger time frames and identifies patterns that are indicative of a possible market reversal. TD Camouflage requires that, for a call buying opportunity at a suspected market low, the current day’s low must be less than the previous day’s low and the current day’s close must be less than the previous day’s close, but at the same time the current day’s close must be greater than the current day’s open. In this scenario, we would look to execute a small portion of our low-risk call-buying position at the close of the pattern day and the balance at the opening of the following day. Conversely, for a put-buying opportunity at a suspected market high, the current day’s high must be greater than the previous day’s high and the current day’s close must be greater than the previous day’s close, but at the same time the current day’s close must be less than the current day’s open. In this scenario, we would execute a small portion of our low-risk put-buying position at the close of that day and would purchase the balance on the next day’s open. In each instance, the critical price relationship and comparison exists between the current bar’s open and close, whereas most traders concentrate upon the less-important and -relevant relationship between consecutive closes.

Our primary trading style with TD Fib Range, TD Exit One, TD REBO Reverse, and TD Camouflage is to simply buy the call or put option outright upon reaching these price levels and objectives. However, if these indicators conflict with the overall market picture, we will consider trading a long option spread so we do not have to put up as much money and can still participate in the market’s move. Our exit points are obtained once a profit target is reached or, if one were so inclined, once an intraday indicator reading in the opposite direction is recorded. Our stop loss levels are either nothing at all in cases where the options are cheap or we don’t have a large position, or simply a dollar loss in cases where the options are expensive or we have a large position.

TD Range Projection. We utilize TD Range Projection to approximate the following day’s price range. While this indicator can also be used intraday, we prefer a broader time frame, such as hourly charts, and prefer to use this indicator to project daily ranges. To arrive at TD Range Projections, three mathematical formulas are applied depending upon the current day’s relationship between the close and the open. While we can use TD Range Projections to make trading decisions outright, it is primarily used to confirm other indicators and form opinions as to the probable direction and price activity of a particular market.

How one trades TD Range Projections is determined by the opening price relative to the projected high and low. If the market opens within the projected high and the projected low, a trader can expect resistance at the projected high and support at the projected low. In this instance, when price exceeded the projected high to the upside, a low-risk put-buying opportunity occurs; conversely, when price exceeded the projected low to the downside, a low-risk call-buying opportunity occurs. If the market opens outside the projected range, meaning it opens above the projected high or below the projected low, it qualifies as a possible price breakout, provided price follows through by at least one price tick in the direction of the breakout. In this instance, an option trader can trade in the direction of the trend breakout, by buying calls upon opening above projected high breakout, or by buying puts upon a downside projected low breakout. However, this practice would be described as trend-following and the option premiums would more than likely have already been affected. In addition, if the opening price exceeds the projected high to the upside, then this level would now provide support and should be held on a closing basis; similarly, if the opening price exceeds the projected low to the downside, then this level would now provide resistance and should be held on a closing basis. When trading with TD Range Projections, our exit points are obtained once we are satisfied with our profits or once an intraday indicator reading in the opposite direction is recorded; our stop loss levels are either nothing at all or a dollar loss, depending upon the size and the value of our position.