Options Trading Blog posts page 2

Thursday, May 28, 2020

How to Project Price Targets

I was asked this week whether there is a way to project how far a trend will travel or how long a consolidation phase will last. Quite often the two are related. But in this blog, I will focus on setting price projections after a market has broken free from a congestion phase.

The most common consolidation patterns take the shape of flags (rectangle) and pennants (triangle) in charts. Just before sharp vertical moves, markets frequently have a series of sessions with below average day ranges and decreasing volume. Furthermore, during these low volume periods there tends to be plenty of price overlap and small candlestick bodies.

One method I use to project how far a trend is likely to extend is to count the number of days the market has been developing a flag or pennant. In the example below DIA (Dow Jones industrial ETF) spent 5 days developing a flag- shaped pattern. When the breakout begins, I refer to the 5-day average true range (ATR), because that is how many days the consolidation phase lasted. Next, take that ATR, which is 15 in this case, and measure the distance from the midpoint of the pattern. In this case the breakout was toward higher levels and the midpoint was 245. The sum of the 5d ATR and the midpoint equates to 260, which is the upside target.

This is just one method projecting price goals and should be helpful when setting strikes.

John Seguin
Senior Technical Analyst
Market Mentor Mentoring, Inc.

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Friday, May 22, 2020

Mental vs. Hard Stop: Which to Choose When

What to consider when contemplating stop losses in option trading is a topic that comes up routinely in MTM’s Group Coaching class. When it comes to options, stop losses can be a little tricky. Bid-ask spreads tend to be a bit wider, which means there could be more “ground” to make up than there would be with many equities, which have a tighter bid-ask spread. In this blog I will explain the general rule of thumb I use when it comes to stop losses and options.


When just buying or selling a single-legged option, I tend to use a hard stop if I deem the bid-ask spread reasonable. What is reasonable? That will be for you to decide, and you will form your opinions with more experience. Experience cannot be taught, and in this case opinions are formed over time. I will put in a sell stop loss for long positions and a buy stop loss for short positions. Because there is only a single leg, the bid-ask spread is usually tighter. The screenshot below is a stop loss on a long call position. The current bid-ask spread is only $0.10 wide, so there is less chance for slippage or a worse fill with the exit order set if the position declines to $0.70.


When buying or selling an option spread, a mental stop is usually more beneficial because the bid-ask spreads tend to be larger due to multiple legs. If the bid-ask spreads are generally tight, I still consider using a hard stop but only after becoming profitable on the position. The screenshot below shows a potential vertical call debit spread and a stop loss. Notice that the bid-ask spread is larger than the long call listed above. Here the stop loss is set to exit if the position drops to $0.30 in value. The bid-ask spread is now $0.15 wide instead of just $0.10 like above.

Whether you choose to use mental or hard stops is completely up to you. With the market continuing to be volatile, gaps on the open have become normal. In addition, bid-ask spreads tend to be wider right after the open. Keep that in mind too. I hope this will give you a few things to think about. The important part is that you have a stop loss decided on in the first place.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, May 14, 2020

Use RSI to Navigate Uncertain Markets

Technical indicators can be quite helpful when fundamentals are absent. Now more than ever traders need to interpret price action using charts because the stock market lacks guidance. Earnings estimates and guidance mainly drive stock prices. With much of the economy shut down and the uncertainty of when it will be running at full capacity again, it is difficult to predict earnings or the possible collapse of a company or industry. The future is unclear, which makes traders anxious, and nervous traders tend to shy away from stocks and into cash or fixed income securities. Treasury and precious metal ETFs tend to do well when the future is hazy.

When fundamentals are lacking, I refer to a few technical indicators to guide my trading decisions. One of my favorites is called the Relative Strength Index, or RSI. This is classified as a momentum oscillator that measures speed and length of directional moves. It is computed as a ratio of higher closes to lower closes. More positive changes lead to a higher RSI. The scale is measured on a scale from 0 to 100. Many traders use RSI to define if a stock is overbought and has a reading over 70. On the other hand, an oversold situation arises when the RSI dips below 30. The issue I have with this method is that a market can ride that 30 or 70 line for quite some time. Thus, if you are long options it may take weeks for the market to turn in your direction. Meanwhile, time decay can seriously affect your position.

The most reliable way I have found to use RSI is to recognize divergence. When a market rises above a previous high and the RSI does not do the same, it is considered divergent. And when a new low is realized and the RSI does reach a new low, it is also divergent. The SPY daily chart below illustrates this spectacle for an up and down move.

Trend reversals frequently occur when the there is a divergence between the RSI and price. In mid-January SPY topped out around 335, and then about a month later it made a new high around 340. Note that the RSI did not probe to a new high and a major downturn soon followed. The opposite occurred in late March when stocks bottomed out. All technical indicators have validity at some point; none works all the time. Some are meant to determine trend strength while others are designed to indicate trend exhaustion. RSI can be used for both.  

John Seguin
Senior Technical Analyst
Market Mentor Mentoring, Inc.

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Wednesday, May 6, 2020

What Does a Bullish Base Look Like?

I talk about bullish bases in group coaching class practically every day. The market has been predominantly bullish, but what does a bullish base look like and how can we use it for a potential bullish entry? Here is a short blog explaining what it is and what to look for.

A bullish base forms when a stock moves considerably higher, usually over a short period of time, and then begins to trade sideways. To me, the question becomes, what is sideways? If the stock does not pull back more than two-thirds of the move higher, it is a bullish base. For example, if a stock moved higher from $50 to $56 and then traded sideways and never closed below $54 (6 X 2/3), it has formed a bullish base. But at the same time, the stock is stuck under some resistance that it has had trouble trading above.

Take a look at this recent example of Tesla Inc. (TSLA) on an hourly chart below.

The stock rallied from just above the $450 area and traded all the way to previous resistance around the $545 level. Looking in late March, the $545 area produced a bullish base too, but the stock was not able to clear resistance. Not all bullish bases move higher. But in early April, it rallied to that same area and did not pull back more than a third of the move higher. In this case, it barely pulled back. Fast forward and take a look what happened to TSLA about a week later.

The stock exploded to the upside once the resistance level was toppled. Big moves like this are not common but can clearly happen in the right environment. I put this stock on my bullish watch list but did nothing (bullish directionally) until it broke the resistance level. For me that constitutes a 2-bar bullish close (2 consecutive bullish closes above resistance) on the daily chart. But at the same time, selling put credit spreads below the support level could have been considered as well.

Determining what a bullish base is can be fairly easy if you know what to look for and consider. Just because it is a bullish base does not mean it will eventually move higher. Resistance like support still has a better chance to keep the stock from moving higher. As traders we always want to put the odds on our side, and for me that would be a break above the resistance level particularly when it forms a bullish base.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Friday, May 1, 2020

Using Double Distributions to Identify Trends

To be a good market analyst and trader, you should make it a point to learn intricate details that are illustrated in charts. The study of charts or technical analysis is what most trading systems are built upon. Learning and problem solving are a big part of artificial intelligence (AI). The idea is to get a machine to think and react like a human. Machine-based learning is dependent on pattern recognition and repetitive responses. Think cause and effect. Early pattern recognition is integral for timing entry and exits in stocks and commodities.

One pattern that I trust to identify the onset of trend is defined as a double distribution day. I prefer using 30-minute bars to scan markets for this phenomenon. It is a short-term momentum indicator that frequently occurs in the early stages of trends. This pattern normally reveals itself around midday. It typically precedes a few days to a week of choppy trendless trade, otherwise known as a consolidation phase. During this phase, the day ranges tend to be below average and volume usually tapers off to below average levels. Furthermore, there is a tendency for daily opens and closes to be near each other, which is an indication of neutrality. On the day the position is taken, the first hour range is typically below average as well. When all these elements are evident, odds for a sharp vertical are peaking.

This SPY chart from last week shows just how this pattern takes shape. A few sessions of sideways trade prompted an alert that a breakout was about to occur. Around noon on the third day, the market accelerated higher leaving a candle with no overlap in the next 30-minute period. From there another distribution began to form. Double distributions within a day session frequently ignite an above average vertical move. This pattern does not happen often, but it seems to occur more often following three to five days of neutral price action.

John Seguin
Senior Technical Analyst
Market Taker Mentoring, Inc.

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Thursday, April 16, 2020

3 Things You Need to Know Before You Trade a Straddle

It’s shocking. Most people simply don’t make money trading straddles—even when things are volatile. Why, you ask? It comes down to just 3 simple factors that are often overlooked by traders. And once you know them, you’ll be a better trader in all situations—especially when expecting high volatility.

How Straddles Work

Straddles are simple—on the surface anyway. Expecting a big move, but not sure of direction? That’s what straddles are for. Buy a call and a put with the same expiration and strike. If the stock goes up, the calls make more than the puts lose. If the stock goes down, the puts make more than the call loses. Win-win. Brilliant!

But here’s the rub…

The 3 Things to Know About How to Trade Straddles

No. 1: You are not the only person looking at the market

I know. It’s shocking, right? No. Right now there are literally millions of people looking at every stock that trades. They read what you read. They use the same analysis you use. The “wisdom of crowds” theory states there’s a good chance they have pretty similar thoughts about that same stock as you do. And… Some of them beat you to the punch.

You can bet your last dollar some traders bought that straddle before you. And there are others who just bought the puts as a hedge or bought calls as a spec. The demand has already begun to drive the price of those options higher (this is the effect of implied volatility).

If you think of the “value” (value in the classic sense, meaning usefulness) of a straddle being that you can make money if you see the volatility you expect, you pay for that value. And just like anything else that has value, at some point, the price can be so high it’s no longer worth it.

Here’s how that plays out with this option strategy…

No. 2: There ain’t nothin’ in this world for free

With a straddle, you’re buying the benefit of being able to make money whether the stock goes up or down. But it’s not really the total cost you pay for the straddle that is the most important factor (you can sell it later, so the straddle price isn’t really the cost). The true cost is more like the “daily rent” for having this benefit: “theta.”

All options lose value as time passes. That’s called time decay and it’s measured by one of the metrics we use to make smart option trading decisions—the option Greeks. The option Greek that matters here is theta.

Every day the stock doesn’t move enough, you lose a little bit on this “daily rent.” And that’s a fair trade-off. After all, you’re betting on increased volatility. The bet is: You get volatility you make money; you don’t get volatility you lose money.

But when demand is high for the straddle, the total cost of the straddle is higher. That also means the theta is higher. It’s running against the wind a bit. But if you get enough volatility, you can still win.

That, however, is complicated by our final thing to know about trading straddles…

No. 3: The wind gets stronger

We have to get in the weeds a little bit here. But here we go…

As shown, when implied volatility rises, theta rises. But the other relevant option Greek here is a second order Greek called “gamma.” In a nutshell, gamma, in this case, is how much money you make on your straddle given a unit move in the stock.

When gamma is high, if the stock moves up or down, say 1%, you make more than you do when the gamma is low—sometimes a lot more. Many traders don’t look at this. But this actually determines whether you make money. It’s the most important factor of all.

But here’s the thing, when implied volatility rises, not only does theta get bigger, but gamma gets smaller. This is what I like to refer to as “the double whammy.” It’s sort of like running against the wind—with ankle weights on.

Beating the Game

Knowing these 3 key factors is a game changer when it comes to trading straddles. This will help you select better trades, avoid trading the bad ones and set better expectations to pick better profit taking targets.

If you want to make straddle trading work, the first thing to look at is that implied volatility number. If it’s too high, the straddle might be “priced out,” making the prospect of a winning trade too much of a challenge. But here’s a little trick…

Look back at where the stock traded in the recent past to get a feel for how far it might reasonably move. Then look at the price of the straddle at a strike price that distance away from your strike price. This is what I call “the gamma hack,” and it’s a great estimation for how much you would make given a reasonable expectation for volatility. Then you can easily decide if the trade is worth the risk.

For example, imagine you’re looking at the $230 straddle priced at 9.25. The recent trading range shows an $8 move is reasonable over the next couple of days. Here’s what you do…

Look at the prices of the $222 straddle and the $238 straddle (both $8 away from your strike). Those straddle prices are a great estimate for what the straddle will be worth if the stock indeed moves $8. If the profit is enough to balance the risk of the stock not moving enough, and therefore losing from theta, you can feel good about taking the trade.

But remember, as each day passes, theta works against the trade, so you’ll have to repeat this process every day. If a few days pass and the trade has yet to show a profit, it’s a good time to exit and move on to the next, better opportunity and another chance to bring in some profits.

Dan Passarelli
Founder and President
Market Taker Mentoring, Inc.

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