Learn to Trade Options: Using the Best Technical Indicators

Technical analysis -- or reading a stock's charts -- is a key piece of the Expectational Analysis puzzle. To trade stocks and options successfully, you must be able to identify areas of potential support and resistance, along with other technical factors. But with so many technical indicators out there, how can you tell what's important and what isn't? While every trader would likely have a different answer to that question, I spoke with Schaeffer's Senior Equity Analyst Joe Bell, CMT, to get his take on this "very pure form of analyzing a market," as well as which stock he's watching this earnings season.

Which technical indicator do you prefer to see if a stock is overbought or oversold?

JB: The Relative Strength Index (RSI) is a classic momentum oscillator that is traditionally used to measure when a stock is overbought or oversold. The RSI oscillates between zero to 100, and most people believe a stock is overbought when it is above 70 and oversold when it is below 30. 

You can also use this indicator to look for divergences, which occur when a stock makes a higher high and the relative strength indicator fails to do so. This type of divergence can also occur when a stock makes a lower low and the relative strength indicator fails to do so. There are many other ways to utilize the indicator in your trading, but using it to determine when a stock is overbought or oversold is the most common method for this technical indicator.

What is the MACD and how do you use it in your trading?

JB: MACD is an acronym that stands for Moving Average Convergence Divergence and is a trend-following momentum indicator that demonstrates the relationship between two moving averages of the prices of an equity.  Although traders can adjust which moving averages they use, the 26-day and 12-day exponential moving averages are the most common we reach for. The MACD is calculated and shown as the difference between these two moving averages. A nine-day exponential moving average is then plotted over this MACD and functions as a trigger for buy and sell signals.           

One method to using it is to look for crossovers between the nine-day exponential moving average, also called the signal line, and the MACD. When the MACD falls below the signal line, it is a bearish signal, and when the MACD crosses above the signal line, it is a bullish signal. Depending on my time frame, I may sometimes choose to look for the MACD turning higher and anticipate the crossover before it happens.    

Another popular way to use this tool is to look for divergences. If a security makes a higher high and the MACD fails to make a higher high, it is referred to as a bearish divergence. On the other hand, if a security makes a lower low and the MACD fails to make a new low, it is referred to as a bullish divergence. A bearish/bullish divergence could be an indication that there is a weakening of the trend under the surface, despite the stock making a new high or low.     

Finally, a surge in the MACD to very high/low levels can also signal a stock is reaching an overbought/oversold status and is due for a breather or reversal in trend. This usually occurs when the short-term moving averages move dramatically away from the longer-term moving averages, and could be an indication that we could see a bit of a reversion to the mean.

Are there any moving averages that pundits use that you tend to ignore? If so, are there any under-the-radar moving averages you favor?

JB: I don't have a strong opinion about one moving average over another. At its most basic sense, it is just a derivative of the price and gives you a snapshot indication of the direction of the trend, along with the momentum and strength of a trend. Short-term moving averages are going to be more volatile and change directions much more often than long-term moving averages.              

I tend to use the 200-day moving average as a general indicator of a long-term trend, along with 20-day and 40-day moving averages for shorter trends. I may also pay attention to crossovers of short-term moving averages above or below a long-term moving average -- sometimes referred to as "golden" or "death crosses." This can be used as a timing tool to look for changes in trends.  Overall, I use these in combination with other indicators and not individual buy/sell signals on their own.

When is option open interest most likely to act as support or resistance for a stock?

JB: This is a question that could be answered with an entire book, so I will just cover some of the broader concepts that apply to this type of discussion. Let’s first look at the for basic types of motivations for an option trader:

1. Buying a Call – Trader is bullish
2. Selling a Call – Trader is neutral-to-bearish
3. Buying a Put – Trader is bearish
4. Selling a Put – Trader is neutral-to-bullish

Every single option transaction will be a combination of one or more of the four transactions listed above. Each strategy will have specific outlook that a trader predicts will occur. If they are correct about their outlook, they will profit, and if they are not, they will lose money. 

Whenever an option transaction occurs, it can affect the underlying stock or security’s price. There are option mechanics that explain how and why this happens, but it is well beyond the scope of a Q&A. Buying a call on a stock can create buying pressure on that stock and selling a call can create selling pressure on the stock, but on the other hand, buying a put on a stock can create selling pressure on the stock and selling a put can create buying pressure on the stock. With these mechanics in play, any large amount of open interest consists of some combination of bought-to-open options and/or sold-to-open options. So, when these trades are closed, they can and will affect the underlying stock price.

The larger the option open interest, the more effect it will generally have on the stock’s price as well. Options with strikes that are near the current stock price are also much more actively traded and have a greater effect on a stock price than options that are far out of the money. The key is to try to combine this type of option analysis with other sentiment indicators you are seeing, to get a better feel for what the overall sentiment is of these option traders is. Combining this type of sentiment analysis with technical and fundamental indicators is at the heart of the Expecational Analysis we utilize in trading at Schaeffer's.

With second-quarter earnings season in full swing, are there any specific stock charts you're watching right now?    

JB: I try to develop a trading watchlist that evolves on a daily basis. With earnings season starting this week and really kicking into gear during the next few weeks, almost 90% of the stocks on my watchlists are set to report earnings. Below is one that I will continue to monitor.

Ionis Pharmaceuticals Inc (NASDAQ:IONS)

• The round-number $55 area has been a major area of resistance for the shares since late 2016.
• Can a major catalyst like the earnings report push the shares past this area of resistance?
• Sentiment indicates that most analysts remain neutral-to-bearish toward the stock.  A positive earnings report could spur upgrades, which would help stock overcome this resistance area.
• A lot of short sellers are targeting the stock, with more than 10% of the stock's float dedicated to short interest. At IONS' average daily trading volume, it would take more than 10 trading session for these shorts to buy back their positions. If earnings are strong, the shorts could rush to cover their losses and it would only serve to add more buying pressure.
• MACD turning higher and potentially turning positive as IONS approaches resistance area once again.
• The company reports before the open on Aug. 8. Earnings-per-share consensus is for a loss of -22 cents, which leaves plenty of room for an upside surprise.

Anything else you'd like to add about technical analysis?  

JB: Technical analysis, like sentiment and fundamental analysis, provides an array of tools and measurements to help create the picture of supply, demand, and future possibilities. It does a good job of stripping away everything outside of what actual buyers and sellers have decided to buy and sell a security for. In that sense, it is a very pure form of analyzing a market. I find it most effective when used in combination with other tools, which can add color to the picture and help an investor make an informed decision about making a trade or investment.