Free Options Trading Course

Lesson Three

Technical Analysis for Options Trading

The third lesson in our free options trading course covers technical analysis for options trading which includes identifying support and resistance levels for options trading, using moving averages in options trading, recognizing chart patterns in options trading, and using oscillators and momentum indicators in options trading.

Technical Analysis for Options Trading
Technical Analysis for Options Trading

Identifying Support and Resistance Levels for Options Trading 

Identifying support and resistance levels is an essential aspect of technical analysis for options trading. Technical analysis is the study of past market data, primarily price and volume, to identify patterns and make predictions about future price movements. In options trading, support levels are identified as price points where a stock has historically found strong demand and has bounced off that level. Resistance levels, on the other hand, are price points where a stock has historically faced selling pressure and has failed to break through that level.

Options traders can use support and resistance levels to identify potential opportunities to buy call or put options. When a stock hits a support level, it indicates that the stock is likely to bounce off that level and potentially move higher. Options traders can buy call options with the expectation of profiting from the stock’s upward movement. Similarly, when a stock hits a resistance level, it indicates that the stock is likely to face selling pressure and potentially move lower. Options traders can buy put options with the expectation of profiting from the stock’s downward movement.

Let’s take the case of Betty, who is a bullish options trader and uses technical analysis for options trading. She has been tracking Apple’s stock and identified a three-month support level at $150. When Apple’s stock hits the support level, Betty decides to buy a call option with a strike price of $155 and an expiration date of two months. She pays a premium of $5 per share for the call option, which means she pays $500 for one contract (each contract controls 100 shares).

If Apple’s stock price rises above the strike price of $155, Betty’s call option will be in the money, and she can exercise the option to buy 100 shares of Apple’s stock at the strike price of $155. She can then sell the shares at the current market price, making a profit of the difference between the strike price and the market price, minus the premium paid. On the other hand, if Apple’s stock price does not rise above the strike price, Betty’s call option will expire worthless, and she will lose the premium paid.

It is essential to note that options trading involves significant risks, and traders should have a clear understanding of the risks and potential rewards before engaging in any options trading strategy. For example, Apple stock can rise in price from $150 to $154 three weeks prior to expiration, and the price of the option may decline from $5 to $3, so even though Apple stock rose from the support level at $150 to $154, Betty may still have a loss if she sells the options contract. Using technical analysis for options trading can help traders identify potential opportunities, but even if the stock moves up in price, it is not a guarantee of a profit since options pricing is affected by additional factors.

Identifying support and resistance levels is an important tool of technical analysis for options trading. Traders can use these levels to identify potential opportunities to buy call or put options. However, it is important to remember that options trading involves significant risks, and traders should conduct thorough research and analysis before engaging in any options trading strategy.

Using Moving Averages in Options Trading

Technical analysis for options trading is a popular method that traders use to evaluate market trends and make informed decisions about buying or selling options. One of the most commonly used tools in technical analysis is moving averages. Moving averages are calculated by taking the average price of an asset over a specified period of time, and they can help traders identify trends and potential entry and exit points for options trades.

technical indicators for options trading

Moving averages are an essential component of technical analysis for options trading and are simply calculated by taking the average price of a stock over a certain period of time. For example, a 200-day moving average (MA) is the average price of a stock over the last 200 days. There are different types of moving averages, including simple moving averages (SMA) and exponential moving averages (EMA). The SMA is calculated by adding up the closing prices of a security over a specified time period and dividing by the number of periods. The EMA is similar, but it places more weight on recent price data, giving more importance to recent price movements.

When using technical analysis for options trading, moving averages are often used to identify trends in the market. A rising moving average indicates an uptrend, while a falling moving average indicates a downtrend. Traders can use moving averages to identify potential entry and exit points for their trades. For example, a trader may look to buy a call option when the price of a security crosses above its 200-day moving average, indicating that an uptrend may be starting.

On the other hand, a trader who is using technical analysis for options trading may look to buy a put option when the price of a stock crosses below its 200-day moving average, indicating that a downtrend may be starting. This is a basic options trading strategy that uses moving averages to identify potential entry points for trades.

Options traders who implement technical analysis for options trading can also use moving averages to identify support and resistance levels. When a stock price is trending above its moving average, the moving average can act as a support level. When a stock price is trending below its moving average, the moving average can act as a resistance level. Traders can use these levels to determine where to open or close stock options positions.

Let’s take a hypothetical example of Anthony, who is a trader that uses technical analysis for options trading. Anthony notices that Costco’s stock has been trending upward, but recently pulled back to the 200-day moving average. He believes that the 200-day moving average could act as a support level and the stock price may rebound from this level. To take advantage of this potential opportunity, Anthony decides to buy a call option on Costco with a strike price of $400 and an expiration date three months from now. The premium for the option is $10, so the total cost of the option is $1,000 (100 shares x $10 premium). If the stock price of Costco continues to rise and crosses above the strike price of $400, Anthony will make a profit. The amount of profit will depend on how much the stock price goes up, but it could potentially be significant. The current stock price is $399, so the option is out-of-the-money.

If Anthony’s analysis is correct, and the stock price rebounds from the 200-day moving average, the call option could increase in value. Assuming the stock price reaches $450 by the expiration date, the call option will be worth $50 ($450 – $400), resulting in a profit of $40 per share ($50 – $10 premium). Remember these numbers are per share, and since each options contract is for 100 shares, we need to multiply the figures by 100. Consequently, Anthony’s premium cost is $10 x 100 shares, which is $1000. His profit is $40 x 100 shares, which is $4000. If Anthony’s analysis is incorrect, and Costco stock price continues to decline, the call option may expire worthless, resulting in a loss of the $10 premium per shares, which is $1000 total loss. Anthony will lose the entire premium paid for the option. The risk of loss is limited to the premium paid, but it is still important for traders to be aware of the potential risk involved in any options trading strategy.

Using moving averages in options trading can be a helpful tool to identify potential support and resistance levels, and to make informed decisions about buying or selling call and put options. Traders should always consider the risk and profit potential before entering any options trade. Technical analysis for options trading can be a valuable tool, but it should not be the only factor considered in making trading decisions.

Recognizing Chart Patterns in Options Trading

Technical analysis for options trading involves analyzing market data such as price and volume to make informed trading decisions. One of the key tools used in technical analysis is chart patterns. In this section, we will explore how options traders can use chart patterns to buy or sell call options and put options, and we will include a case study for Jillian who decides to buy a call option on Netflix when the candlestick chart showed a reversal hammer pattern.

Chart patterns are visual representations of price movements that show a recognizable shape or formation. Options traders can use these patterns to identify potential trend reversals or continuations, which can provide insight into when to buy or sell call options or put options. Here are some additional popular chart patterns options traders may want to use:

Double Top and Double Bottom: This pattern occurs when the stock’s price hits a high or low twice and fails to break through that level both times. This can indicate a reversal in the stock’s trend. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help identify these patterns.

Head and Shoulders and Reverse Head and Shoulders: Head and Shoulders pattern consists of three peaks, with the middle peak being the highest (the head), and the two outer peaks being lower (the shoulders). The pattern is complete when the stock’s price falls below the “neckline” which is a level of support that connects the two troughs between the shoulders and the head. Reverse head and shoulders is a technical analysis pattern that forms at the bottom of a downtrend and signals a potential bullish reversal. The pattern consists of three troughs, with the middle trough (the “head”) being lower than the two surrounding troughs (the “shoulders”). This pattern is opposite to the regular head and shoulders pattern, which is a bearish reversal pattern. In a reverse head and shoulders pattern, traders look for a breakout above the neckline, which is drawn through the highs between the shoulders, as confirmation of the bullish trend reversal. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Flags and Pennants: These patterns occur when a stock’s price experiences a sharp move in one direction followed by a period of consolidation (forming a flag or pennant shape). This can indicate a continuation in the stock’s trend, up or down. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Wedges: These patterns occur when a stock’s price makes higher highs and higher lows (ascending wedge) or lower highs and lower lows (descending wedge) within a converging range. This can indicate a reversal in the stock’s trend, up or down. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Cup and Handle: This pattern forms when a stock’s price experiences a U-shaped recovery followed by a small dip and then a move higher. This can indicate a continuation in the stock’s trend. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Candlestick chart patterns are an essential tool for options traders who use technical analysis to identify potential trading opportunities. Here are some additional popular candlestick chart patterns:

Shooting Star: This pattern indicates a potential trend reversal. It occurs when the opening and closing prices are close together, but the high is significantly above the opening price, creating a long upper shadow. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Inverted Hammer: This pattern is similar to the shooting star but is a bullish reversal signal. It occurs when the opening and closing prices are close together, but the low is significantly below the opening price, creating a long lower shadow. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Spinning Top: This pattern indicates indecision in the market. It occurs when the opening and closing prices are close together, and the high and low are also close together, creating a small real body. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Doji: This pattern also indicates indecision in the market. It occurs when the opening and closing prices are the same, creating a small real body. However, the high and low can vary, creating different variations of the doji pattern. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Hanging Man: This pattern is similar to the hammer but is a bearish reversal signal. It occurs when the opening and closing prices are close together, but the high is significantly above the opening price, creating a long upper shadow. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Morning Star: This pattern is a bullish reversal signal. It occurs when a long bearish candlestick is followed by a small real body that gaps down, and then a long bullish candlestick. This pattern signals that the bears have lost control, and the bulls are taking over. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

Harami: This pattern consists of two candlesticks, where the first candlestick is a long one and the second is a short one. The short candlestick is completely contained within the body of the longer candlestick, and it signals a potential trend reversal. If the first candlestick is bullish and the second is bearish, it is called a bearish harami, indicating a possible shift from bullish to bearish sentiment. On the other hand, if the first candlestick is bearish and the second is bullish, it is called a bullish harami, indicating a possible shift from bearish to bullish sentiment. Options traders can use this chart pattern to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these chart patterns.

CHART PATTERNS IN OPTIONS TRADING CASE STUDY

Jillian is an options trader who is always on the lookout for profitable trades using technical analysis for options trading. She has been following the stock price of Netflix for a while and noticed a bullish reversal hammer pattern on the candlestick chart. She believes that this chart pattern indicates a potential uptrend in the stock price of Netflix.

After conducting further analysis, Jillian decides to buy a call option on Netflix with a strike price of $200, as she believes the stock price will increase in the near future. She purchases the call option at a premium of $7 per share, which gives her the right to buy 100 shares of Netflix at $200 per share until the expiration date of the option.

A few weeks later, the stock price of Netflix increases to $240, which means that Jillian’s call option is now worth $40 per share. She decides to exercise the option and buy 100 shares of Netflix at $200 per share, and immediately sells them at the current market price of $240 per share.

To calculate Jillian’s total profit from the trade we can use the following formula:

Profit = (Option value at expiration – Premium paid) x Number of shares

Profit = ($40 – $7) x 100 = $3,300. Jillian’s profit from the trade is $3,300, which is a significant return on her investment. By using technical analysis for options trading, Jillian was able to identify a profitable opportunity and make a successful trade.

Technical analysis for options trading involves using chart patterns to identify potential trend reversals or continuations, which can provide insight into when to buy or sell call options or put options. As with any trading strategy, there are risks involved, and traders must carefully consider the potential risks and rewards of each trade. In our case study for Jillian, she used the reversal hammer pattern to inform her decision to buy a call option on Netflix, but it is important to remember that chart patterns are not always reliable indicators.

Using Oscillators and Momentum Indicators in Options Trading

Technical analysis is an essential tool for options traders to predict stock price movements and make informed trading decisions. One common technical analysis tool is the use of oscillators and momentum indicators. These indicators help traders identify trends and momentum shifts, which can be useful in buying or selling call or put options.

An oscillator is a technical indicator that measures the relationship between the current price of an asset and its moving average. One popular oscillator is the Relative Strength Index (RSI). The RSI is a momentum indicator that measures the speed and change of price movements. When the RSI is above 70, it indicates that a stock is overbought, and when it is below 30, it indicates that the stock is oversold. Traders can use this information to buy or sell options depending on their market outlook. Options traders can use this technical indicator to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these options trading opportunities.

Another popular oscillator is the Moving Average Convergence Divergence (MACD). The MACD calculates the difference between two moving averages to identify changes in momentum. Options traders can use this technical indicator to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these options trading opportunities.

Momentum indicators are also an essential part of technical analysis. They measure the strength of a trend and can help traders identify potential reversal points. One popular momentum indicator is the Stochastic Oscillator. The Stochastic Oscillator measures the closing price of a stock compared to its price range over a specific time period. When the Stochastic Oscillator is above 80, it indicates that the stock is overbought, and when it is below 20, it indicates that the stock is oversold. Traders can use this information to buy or sell options accordingly. Options traders can use this technical indicator to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these options trading opportunities.

Commodity Channel Index (CCI): This indicator measures a stock’s price relative to its average price over a specified period of time. Traders often use the CCI to identify trend reversals and to generate buy and sell signals. Options traders can use this technical indicator to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these options trading opportunities.

Williams %R: This indicator measures a stock’s price relative to its trading range over a specified period of time to identify overbought and oversold conditions. Traders often use Williams %R in conjunction with other indicators to confirm signals. Options traders can use this technical indicator to buy or sell call options or buy put options. Technical analysis for options trading can help option traders identify these options trading opportunities.

It is important to note that oscillators and momentum indicators are not foolproof and should be used in conjunction with other technical analysis tools. Traders should also be aware of the risks involved in options trading, including the potential loss of the entire investment.

USING OSCILLATORS IN OPTIONS TRADING CASE STUDY

Robert is an experienced options trader who has been using technical analysis for options trading for many years. Recently, he has been keeping a close eye on the 14-day RSI of SPY, which is a momentum oscillator used to identify overbought or oversold conditions in a particular stock or ETF.

When conducting technical analysis for options trading, Robert noticed that the 14-day RSI of SPY had dropped to a level of 28, indicating that the ETF was oversold and due for a rebound. Based on this information, Robert decided to purchase a call option on SPY, with a strike price of $400 and an expiration date of one month from now.

Robert believed that the oversold condition of SPY, as indicated by the low RSI reading, would cause the stock to rebound in the coming weeks. He purchased the call option for $5 per share, which gave him the right to buy 100 shares of SPY at the $400 strike price.

Over the next few weeks, SPY began to rebound, and Robert’s call option gained value. When SPY hit a price of $420, Robert decided to exercise his option and buy 100 shares of SPY at the $400 strike price. He then sold the shares for $420, making a total profit of $1,500 on his call option trade.

Robert’s use of the 14-day RSI at a technical analysis for options trading tool to identify oversold conditions in SPY allowed him to purchase a call option at a low price, which he was then able to sell for a significant profit. This is an excellent example of how options traders can use technical analysis for options trading to identify profitable trading opportunities.

Technical analysis for options trading can help option traders identify options trading opportunities. Oscillators and momentum indicators are useful tools for options traders to predict price movements and make informed trading decisions. However, they should be used in conjunction with other technical analysis for options trading tools and should be approached with caution. Understanding the risks involved in options trading is crucial in maximizing potential profits and minimizing potential losses.

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