3 Things Options Traders Should Know About Technical Indicators

Technical indicators can help determine potential points of support and resistance for a stock

Feb 15, 2017 at 3:13 PM
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    Technical indicators can help determine potential points of support and resistance for a stock, and help options traders identify opportune entry and exit prices. Today, we turn to Schaeffer's Senior V.P. of Research Todd Salamone for more information on which technical indicators to use -- and which to avoid -- to make better trades.

    In your opinion, what are the best technical indicators for a beginning options trader to watch?

    TS: I think it is best for beginning options traders to keep three things in mind with respect to technical indicators and options trading:

    1. Get familiar with a few technical indicators that you are comfortable using and keep it simple. When I say "keep it simple," I do not necessarily mean use a technical indicator that is in the mainstream and very easily accessed, as this can get you into crowded trades with little reward versus risk. Instead, use indicators that you can access, but put your own twists on them based on the research you did on the underlying. For example, it is common knowledge among those in the technical community that the 200-day moving average is a popular trendline on the radar of many traders. But, if you notice that an underlying respects another longer-term moving average, such as its 120-day -- roughly equivalent to its six-month average price -- consider using this trendline as an entry point on pullbacks.

    2. Ensure that the technical indicator or set of indicators that you are using matches the time frame of the options you are playing. When trading options, there are a number of options for you to purchase, with various expiration dates. Therefore, ask yourself, "What is my target and how much time do I think I will need based on the technical indicator that I am using?" So, if you are pretty certain a short-term oversold condition will eventually lead to a resumption of an uptrend, but you think it could take weeks to play out instead of days, purchase an option that expires 2-3 months from now instead of an option that might be cheaper on an absolute basis, but expires in only a few days.

    3. It isn't enough to simply identify support or resistance when you are buying option premium. When selling option premium and betting that an underlying will not move below a certain level before a certain date, identifying support or resistance during a certain time frame is sufficient. But when buying option premium, you must identify what is going to move the underlying in your anticipated direction. Is there a catalyst, such as an earnings report or the company appearing at an industry conference? Or, is there an upcoming expiration in which a lot of puts are getting set to expire, and there is the potential that short covering related to this expiring open interest will occur?

    Which technical indicators do you use the most, or find the most useful?

    TS: I try to diversify my set-ups due to the fact that markets are constantly changing. In other words, for call trades, I might buy a breakout or a crossover of a moving average that typically capped the shares, but I buy sufficient time in case the underlying pulls back to retest the breakout or crossover level before continuing in the direction of the breakout. This tends to serve better in market environments in which there is a lot of sector rotation.

    At the same time, I might also get call exposure to an equity already in an established uptrend that is pulling back or consolidating into an area of support, such as a former resistance level or prior area of support. Moreover, I don't rely on any one particular technical indicator as a driver for a trade. But I am aware of moving averages, overbought/oversold conditions, and past areas of support and resistance, and I combine these with what I am observing with sentiment indicators, options analysis, and weighing reactions to company-specific and sector-specific news. 

    Are there any "under the radar" technical indicators that you use for trading?

    TS: I am not sure if this is necessarily "under the radar" or not, but I try to identify areas of potential resistance/support based on where I think profit-takers may take control or buyers may step in. For example, if I saw that a stock based for a period of time with the lows at $14, I might anticipate $21 to be a potential profit-taking zone for those that purchased the stock at $14 and are looking to cash in a round 50% profit. This $21 level could be viewed as a speed bump, and dictate how much time I buy for my option if I open a call trade and believe $21 will be only a short-term hesitation point before the uptrend continues. Or, with a combination of other drivers, this level could be used to time an entry into the purchase of a put position if I believe resistance at this level could lead to a more sustainable sell-off over a given period.

    Which technical indicators do you find to be overhyped?

    TS: I typically find those indicators that you see being discussed widely on social networks and/or the media historically are not reliable signals. Typically, this relates to the broad market. For example, as the market clawed its way higher in the early days after the bear market ended in 2008-2009, some technicians voiced concerns about low volume. A rally on low volume was perceived as an advance built on an unreliable foundation that would eventually give way to more selling.

    Moreover, there have been many skeptics who are loud when they see a bearish "head and shoulders" pattern forming, but are unheard or even fail to see an "inverse head-and-shoulders" pattern, perhaps due to a bearish predisposition. So, if you see an indicator getting a lot of play, do research on the historical implications before taking it to heart. Also, realize that if you play a pattern after you see many discussing it, realize that you might be late to the game, or getting yourself into a crowded trade that in real-time does not have the same risk-reward that it has had historically. 

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