Why Market Analysis Is Critical When Option Trading

It goes without saying that understanding options and various option strategies is crucial for an option trader, but market analysis is also critical in option trading. Smart traders and investors use diligent market research to get a better grasp of the market, which can give them an additional edge as an option trader. In group coaching class, I often talk about how essential it is for traders to take into consideration the overall market sentiment when choosing strategies. Personally, I weigh the overall market in at at least a third of my decision-making process when it comes to selecting option strategies.

What Is Market Analysis?

Stock market and option market analysis is similar to market analysis in other industries. Market analysis provides information about industries, customers and other market variables. You can use this to determine the relationship between supply and demand for a specific product or service. This allows you make a potentially more informed decision.

Having an idea about the overall market or an individual market can give an option trader a huge advantage. Trading is all about putting the odds on your side and applying the best strategy to take advantage of those odds. If you feel a market or individual equity may move in a certain direction because of technical analysis, fundamental analysis or both, you are doing market analysis.

How to Use Market Analysis in Option Trading

Finding profitable trading opportunities can be tough in any market and certainly some markets seem tougher than others. But you don’t have to do all the work yourself. Some professional trader services can make it much easier to analyze the market. Many of these are paid services, but they can also save you a lot of time. And sometimes that is more important than money.

Whether you do your own research or rely on a seasoned professional for your analysis, it’s essential to understand some basic facts about options trading.

Making option strategy assessments based on individual stock assessment requires an understanding of specific fundamental parameters. Traders may learn how to read an annual report and 10K stockholders report for income statements, past earnings, sales, assets, new products and overall industry trends.

Technical Analysis

Planning option strategies based on technical analysis is essential for success and requires the trader and/or investor to examine the historical price movement and volume to determine price patterns and forecast future price movement. The famous saying about how to predict the future of a stock chart is to look to the left. In this case, past performance is indicative of future behavior.

The single most important technical analysis technique is the simplest: support and resistance lines. Specifically, horizontal support and resistance lines at the same price level in two or more multiple time frames. Sometime once can be enough like an all-time high or a recent low. Knowing that support and resistance have a better chance of keeping the underlying from moving through effectively puts the odds on your side.

Broad Market Analysis

Planning option strategies based on broad market analysis examines overall activity based on performance indices. Is the overall market bullish (moving up), bearish (moving down) or neutral (moving sideways)? Potential support and resistance levels are just as important here. The broad market will affect individual equities, and don’t forget to take into account implied volatility and possible changes that could help or hinder your option position.

Psychological Indicators

In addition, option traders will analyze markets based on psychological market indicators and attempt to interpret the facts and gauge whether a change from bullish to bearish (or vice versa) is on the horizon. Successful options traders are frequently contrarians who buy puts in a bullish market and purchase calls in a bearish market — against convention.

Bottom Line

As you probably know already, a lot goes into determining what position to enter as a trader. Option traders have even more options to think about. Either doing it on your own or using the help of a professional with experience in “putting it all together” can make the process easier and can result in better trade ideas with greater profit potential.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.