Refine Your Option Trading Strategy with Candlestick Charts

OPTION TRADING REFINED

"If you want to succeed, you should strike out on new paths rather than travel the worn paths of accepted success".

Options are the high-risk investment vehicles—or so it is thought by the majority of investors. Why are options considered high risk? Simple. Most investors lose money in options. Statistics show that over 80 percent of all option trades lose money. Why is this so? Because the odds are stacked against winning from the start, due largely to three factors:

• First, as with all investments, the direction of price movement has to be correctly analyzed. This procedure alone is a major hurdle for the vast majority of investors.
• Next, the magnitude of the price move has to be correctly calculated— another procedure that has not been perfected by the average investor.
• On top of all this, being correct as to the time element is added.

The combination of these three essential factors is extremely difficult to access correctly. And to add insult to injury, a premium is built into the option price. This premium reflects the speculative fervor of the market participants who think prices will move in their direction. The highly leveraged method of participating in the move creates a parasitic premium that is added to the true value of the option.

How do Candlesticks turn disadvantageous probabilities into advantageous trading profits? The signals that have been described to this point can be applied to align the elements of success, namely, signals, stochastics, market direction, and so forth. A few simple processes can be employed, that will exploit the same factors that make other investors lose money and put money in your pocket.

Direction

As you study Candlestick signals, you will discover that the improvement in accuracy will be quite noticeable. Under certain circumstances, the accuracy probability becomes extremely high. When all the essential indicators line up for a successful stock trade—for example, the signal showing strong buying, the stochastics below the 20 line, further confirmed by a bounce off a trendline, and overall market direction, and so on—an option trade can be executed.

As in all the equations for producing a profit, direction is the first consideration. Obviously, a clear and decisive signal is the reason for considering the trade in the first place. Knowledge of the reversal signals creates a huge advantage for exploiting short-term market moves. Especially profitable is the ability to pinpoint absolute bottom signals. Not only is there the benefit of purchasing an option at the ultimate lowest price, the premium or speculative fervor is also at its lowest point. This creates a double upside reward. As the price of the stock goes up, the option price goes up and the speculative enthusiasm expands the premium. Along with direction, the potential magnitude of the move has to be determined.

Magnitude

An analysis of a stock trade incorporates the potential magnitude of the price move. To briefly review, this involves analyzing where the next resistance or support might occur. Speed and magnitude of the previous move that is reversing is one factor. Congestion levels above the reversal area is another. Trend-lines and Fibonacci retracement levels are more considerations. But most importantly, the signal itself dictates how strong the move could be. A major reversal signal, compounded with a gap up, will substantiate a much stronger advance than a secondary signal. The status of the stochastics should indicate how long the upside move can potentially be maintained. The analysis of the upside is going to dictate the ultimate trade strategy. And this has to incorporate the final element: timing.

Timing

The weakest area of analysis for most option traders is the evaluation of time constraints. This is the area where human weakness is mostly like to be involved. The direction and the magnitude not only have to be correct, it has to be correct in the proper time frame. For every day the trade is in existence, time is working against the profits. This is experienced in two ways. First, the potential of the opportunity of a big upmove lessens as the time for it to occur lessens. Secondly, as time diminishes, so does the investment fervor. Premiums also diminish as time passes away.

Time also becomes a major determinant in the type of option trade that should be established. Three weeks remaining before expiration has a different trade strategy than one week remaining. A two-month option has different strategies than a two-week option. The length of time to expiration dictates how to position the trade.

Emotion is the major culprit causing trades to lose money in 80 percent of option trades. Most call option buyers purchase the call due to some reason they think will make the stock go up big. For example, let's say the time frame is two weeks before expiration date. After the commitment of funds to the trade, the price does move up. Unfortunately, it does not move in the magnitude or speed to offset the diminishing premium built into the option price. Being correct in the direction of the move feeds the ego. The trade was correct. But if the magnitude of the price move was not great enough to offset the cost of the option premium, an emotional dilemma is created. Should the trade be liquidated or will the price move further, significantly more than its norm, between now and the remaining time to expiration? Gone is the original trade expectations and in comes hope for a positive resolution to the trade.

Establishing Profitable Trades

Even after evaluating direction, magnitude, and time, options still contain aspects that work against producing profitable trades,the bid/ask spread. Even with ultra-low commission fees, the cost of entering and exiting a trade can be substantial. This amplifies the necessity of executed trades that have high probabilities of being correct. The percentage loss, on failed trades, exacts a greater price than seen in other trading entities. As illustrated in the following example, failed trades take a toll on an account rapidly.

For example, a stock trading at $65 bid and $65.30 ask has three weeks to go before expiration date. Currently, the $65 strike price is trading at

$4.10 Bid

$4.30 Ask

The purchase is put on at $4.30. The speculation is that the stock price can go up at least 10 percent to approximately $71 in the next three days. This should take the price of the options up to $8.50 or so; however, nothing happens to create that move. The stock pulls back slightly to $64.75. Essentially the trade did not work. It is time to get out. Now the price of the option is

$3.65 Bid

$3.95 Ask

Exiting on the bid side, this fizzled trade cost $.65 on a slightly depressed price action. The price of the option reflects the loss of stock value as well as the loss of time premium. This creates a loss of over 15 percent. It does not take a lot of bland stock price moves to deteriorate a substantial portion of an option trading account. This should emphasize the benefits of placing as many controllable probabilities in your favor before a trade is established.

Using the steps for putting on a successful stock trade becomes all that much more critical when putting on an option trade. Each step needs to be scrutinized. Especially the final step, watching how a stock price will open. If you followed the other steps-analyzing market direction, evaluating the sector chart, identifying a strong Candlestick reversal signal, and seeing the stochastics in the proper area-then the final evaluation becomes an important element of the whole process: How is the stock price opening? The rea-son this step is vitally important is due to the time constraint on the trade.

A strong reversal signal followed by a Candlestick formation that would indicate a day or two of consolidation is crucial if there are only twelve more trading days to expiration. Three days of consolidating will dramatically diminish the time value of the option price. The open of the trade day should demonstrate strong buying presence: a slight gap up or at least opening in the same price range as the close of the previous night. The further away the option expiration date, the less critical it becomes. But common sense would ask, "Why put on the trade if a weak signal appears the next day?" Wait a couple of trading days to see when the consolidation is over and the new buying comes into the stock price. If it still appears to be a good trade, you should be able to pick up the opens at a lower price, the time premium having reduced.

As illustrated in Figure 12.1, the opening price demonstrates that the buying is still present after the bullish Engulfing Pattern signal. This is an indication that price is not weakening due to the lack of buyers.

An option trade has better probabilities of succeeding, in the time frame available, when the signal shows continuous buying after the signal. Figure 12.2, representing Maxim Integrated Products Inc., gave a warning that the buyers had stepped away by its weak open. A Morning Star formation followed by a lower open the next day reveals that the buyers stepped away. This led to the consolidation for the next few days and then the buying resumed. But for an option trade, witnessing the lower open the next day creates an extensive risk element. Even though the Morning Star formation created a high probability that the trend would be up, the weakness of the next open clearly demonstrated that the signal was going to be effective after some waffling. Valuable time and option premium would have been used up.

The image of option trades is usually the high risk, homerun-hitting returns from a highly leveraged investing. Just the mention of options scares most investors. However, options do have their advantages in certain situations. The most dramatic illustration would be buying 1,000 shares of a $37 stock. It is targeted to hit 45 over the next 6 trading days. The call option,

 

strike price $35, is trading at $5.50. Its expiration date is 21 days away. Buying the stock put $37,000 exposed to the market to make $8,000, a 22-percent return in just over a week. Not bad. Buying 10 options costs $5,500 exposed to market risk. If the stock price hits $45 in the projected time period, the option price goes to $11.50 in six days. A 110-percent profit in six days, quite a bit better. Depending upon the analysis of market conditions, the option trade may be the safer of the two trades. If the market in general is in the condition of crashing prices on bad news, owning the stock may carry the bigger risk. An unexpected earnings warning, in certain market atmospheres, can crater a stock price. The stock could gap down the next morning to $25. This would have resulted in a $12,000 loss by owning the stock. The option would have lost what was put into them, the $5,500. In this instance, options were clearly the better play considering the market conditions.

Candlestick signals reduce the probabilities of being caught in a surprise situation. Unfortunately, it can still happen, but not nearly as often. When the Candlestick signals indicate buying pressures appearing in a stock price. The smart money is not often fooled.

Strategic Option Spreads

Using the known statistics to your advantage can produce large profit capabilities. It is known that 80 percent of the option trades loss money. Since that is the case, exploit that knowledge. The Candlestick signals provide clear directional information—the key element for establishing a trade opportunity. The magnitude becomes an evaluation process and the time factor is a known entity. If direction and time are established portions of the total equation, then magnitude becomes the unknown factor. How can the unknown factor be fully exploited? The target price of a move can be estimated by resistance levels from trend-lines, congestion areas, and Fibonacci numbers. These are projected target prices based upon having a high degree of probability that prices are heading in that direction.

Another known fact is that premiums are built into the price of options. The speculative exuberance is captured by the convenience of a leveraged investment vehicle being available. The greed factor—being able to take a little money to make inordinate profits—keeps options priced above their intrinsic true value. Knowing that investors are paying too much for a trade that loses 80 percent of the time adds a valuable dimension. Now there is a method to exploit the unknown factor.

Use the same example as above. A stock is trading at $37 a share. The $35 call option strike-price is $5.50. The difference in this example is the expiration date is eight trading days away. This changes the picture entirely. Before, when the price moved to $45 over a six-day period, there was still enough time until expiration for some of the premium to remain in the price of the option. Now when the price gets to $45, expiration will be within two days and no premium will remain in the option price. How can this trade be best positioned? What is the best risk/return formula?

Analyze the possibilities. The target is $45. The options are priced as follows:

$5.50 $35 strike price

$2.50 $40 strike price

$ .95 $45 strike price

If the confidence level is high for hitting the target of $45, the following scenarios are what the average option speculator would evaluate. Buying the $35 call at $5.50 requires the stock price to go to $40.50 just to break even. Hitting the $45 price makes $4.50, or an 82-percent return.

Buying the $40 strike price at $2.50 requires the stock to hit $42.50 just to break even. Hitting $45 doubles the money invested. Buying the $45 for $.95 makes no sense if it is not targeted to go above that price. It will expire worthless and $.95 of exuberance will be gone.

This is the time to apply a spread trade. The more aggressive investor would shoot for the bullish spread. Buy the $40 calls at $2.50 and sell the $45 calls at $.95. The cost of this trade is $2.50 minus the $.95, a net outlay of $1.55.

$2.50 - $.95 = $1.55 net outlay

This improves the equation immensely. Now the break-even is $41.55, above the level of break-even of buying the $35 calls and below the breakeven of buying the $40 calls. However, the upside percentages change dramatically. If the price of the stock is $45 or higher on expiration date, the net return will be $5.00. If the stock price goes to $47, the net difference between the two call option prices will remain at $5.00:

• Expiration Date - Stock price = $45 or greater
• $45 calls = 0
• $40 calls = $5.00

A $1.55 of investment exposure returns $5.00, a 322-percent gain. Different factors can be weighted in this example as far as downside exposure, including how much could have been lost if the price did not go to $45. The primary point is the use of selling call options to the optimists that are looking for the big leverage move.

The normal question is, "What if the price skyrocketed to $55? You have limited your gains to $5.00. What about all those potential profits that you gave up?" This is the logic that creates the large premiums in options: the hope of that big move that will produce the bonanza trade. Yet, keep in mind that more than 80 percent of option investors lose money. A spread incorporates the knowledge of a price moving in a direction during a set time frame. It also calculates the probable magnitude of that move. Buying one set of calls and selling the higher set of calls exploits the existence of the exaggerated premiums.

You can capture additional profits by taking advantage of the same exuberance that exists on the put side—in this case, depending upon the equity of an account, knowing that the direction of a stock is heading up, and selling the puts (writing puts) can add income to the account. Selling a call or a put requires special margin adjustments. Being able to use the Candlestick signals provides a strong platform for writing options.

Writing Options

It makes good sense for the aggressive investor to use all the profit potential available when finding a strong trade situation. All the reasons for buying a stock position can be transferred to evaluating the options—both calls and puts. A strong Candlestick buy signal that induced the purchase of a stock position might as well be further used for increasing profits on that trade. An analysis of all the factors, the strength of the buy signal, status of the stochastics, and the time remaining until the next expiration period creates the opportunity to put extra profits into the account without any more research analysis. Simple logic implies that if the stock has a high probability of moving upward, the put prices have a good probability of declining. Just as buying a call has a premium that can diminish rapidly as both time and stock price could work against it, the same is true for benefiting from the same factors.

“The ability to convert ideas to things is the secret of outward success.”

Every day that the price goes up, the price of a put diminishes, both from the stock price going against it and the time premium losing the enthusiasm of the bears. The same is true for writing calls against long positions. A long-term position does not go straight up. If an investor's program is to buy and hold, writing calls against the position can greatly enhance returns. As seen in Figure 12.3, representing eBay Inc., the chart illustrates that the stock price had advanced in late January 2001 to the point that a sell signal is occurring when the stochastics show an overbought condition. It is demonstrating a sell pattern, a bearish Engulfing Pattern formation. If the general market conditions collaborate by appearing toppy also, this would be a good time to sell calls against the position. If the probabilities indicate a pullback in the stock price, why not take advantage of that move?

As illustrated in the eBay chart, the sell signal is confirmed by the overbought condition of the stochastics. Additionally, the highs of the past few days have been right at $55. The lack of strength of getting through that level provides a price to consider selling options against the position. The $55 calls can be considered as the optimal strike price. The recent run up to this level should have the premiums at the most exuberant prices. The remaining time before the expiration will be a factor as to which strike price is the most likely to produce added income without getting the stock called away.

Options have many valuable attributes for enhancing returns. The aggressive trader can leverage the results of finding excellent high probability trades. Option trades can be structured to take advantage of the direction of price and time expanse to expiration. Using the option premium to exploit profits can be formulated by implementing spread strategies. Huge profits are not always made on hitting the big option trade, but the potential of megaprofits is what keeps the option premiums consistently overpriced. Trading against the optimism (greed) of the average option speculator creates the opportunity to extract consistent revenue from them. The consistency of those profits creates a compounding effect. Compounding profits will produce much greater returns, with dramatically less downside risk than hitting the big option trade once in a blue moon.

Conclusion

Trading options using Candlestick signals produces an extremely profitable element. Just the aspect of having a high probability of a price moving in a particular direction creates opportunities to manufacture huge profits. Calculations of the three major elements is incrementally expanded by having a handle on that key element. Time and magnitude can then be structured to exploit the correct directional moves. Stripping away one of the major elements variability improves the potential to achieve profitable returns on an expediential basis.