A Technical Approach to Options Trading

For those that are unaware, technical analysis is used as an attempt to forecast future price movement of a given security by examining it’s past price movement. Technicians primarily utilize charts for their analysis and not only look at the historical price movement of the security but also volume and a wide range of technical indicators to help them formulate an opinion regarding the future direction of the price of the security.

There are many approaches to this practice and even more patterns that we could consider, but in this article we will just focus on three basic indicators that some technicians use: support levels, resistance levels and trend lines. After defining how these indicators might be utilized, we can then review what bullish and bearish option strategies might be appropriate.

Support levels

A support level represents a level where a falling stock price stops going down or reverses and goes higher. In other words, it is a price level where buyers tend to be more aggressive than sellers and bid up the stock. Typically the stock price will bounce off this price level on more than one occasion over a period of time to reinforce the notion of support. The presumption is that since the security found support at a given price level in the past, there is a higher likelihood that it will occur again in the future.

Therefore, technicians might be inclined to take a bullish position when the price of the security approaches (or hits) a support level. However, if the stock closes below the support level then one might consider closing out the position since the reason for establishing the position (support will hold) is no longer in place.

Support level example:

Source: StreetSmart Edge®

Trend line - uptrend

Essentially a trend line is a line that is formed by connecting the price levels on a chart where either buyers or sellers tend to step in. Trends can be either up, down or sideways, but we’ll focus on uptrends here. Typically the stock price will bounce off this trend line on more than one occasion over a period of time to reinforce the notion of a trend. In an uptrend (defined as a series of higher highs and higher lows), technicians might be inclined to take a bullish position when the price of the security approaches (or touches) the trend line.  However, if the stock closes below the trend line then one might consider closing out the position since the reason for establishing the position (the uptrend line should provide support) is no longer in place. You can read more about trend trading here

Uptrend example

Source: StreetSmart Edge®

Some potential bullish options strategies to consider if/when XYZ approaches support ($36.00) or the uptrend line:

  • Buy-write:  A relatively conservative strategy which involves the purchase of 100 shares of XYZ and the simultaneous sale of a covered call with a strike price and expiration date of your choice. If the stock is above the strike price at expiration, it will be called away and sold at the strike price. If the stock is below the strike price at expiration, the option will expire worthless but the credit received when the covered call was sold is yours to keep.
  • Long call: You could purchase one or more calls with a strike price and expiration date of your choice. While it might seem appropriate to purchase a long call with a strike price at the support level ($36.00 in the support example above) or whatever price the uptrend line coincides with, keep in mind that at- and out-of-the-money contracts consist entirely of time value, which means that there is no intrinsic value in the price of the option. This generally indicates that you will need a relatively large move in a short period of time in order to offset the negative impact of time decay. The level of risk involved with this strategy typically depends on the number of contracts purchased along with the specific strike price and expiration of those contract(s). If the stock is above the strike price at expiration, the call(s) can be sold or exercised. If the stock is below the strike price at expiration, the call(s) expires worthless and the loss will be equal to the original cost of the call(s). (Note: the call option(s) can be sold prior to expiration).
  • Bull call spread: You could take a little more of a conservative stance (relative to the long call) by purchasing one or more calls at a given strike price and selling an equal number of calls at a higher strike price with the same expiration. Generally speaking, the level of risk of this strategy depends on the moneyness of the strike prices selected (in-the-money, at-the-money, or out-of-the-money) and expiration choice. If both calls are in the money at expiration, you will be exercised at the lower strike price and assigned at the higher strike price. The profit will be the strike price difference minus the original cost of the spread. If both calls are out of the money at expiration, both options expire worthless and the loss will be the original cost of the spread. If the stock is between the two strike prices at expiration, you will be exercised at the lower strike price and you will end up with a 100 share long equity position (for every long call owned).
  • Cash-Secured Equity Put (CSEP):  You could sell a put with a strike price at the support level ($36.00 in the support example above) or whatever price the uptrend line coincides with, or another strike price of your choice, and keep the premium received if XYZ closes above that strike price at expiration. However, keep in mind that you will be assigned a 100 share long equity position in XYZ if the price closes below the strike price at expiration, and if the stock is much lower than the strike price at expiration, the losses could be substantial.
  • Bull put spread: You could take a little more of a conservative stance (relative to a CSEP) by selling one or more puts at a given strike price and buying an equal number of puts at a lower strike price with the same expiration. Generally speaking, the level of risk of this strategy depends on the moneyness of the strike prices selected (in-the-money, at-the-money, or out-of-the-money) and expiration choice. If both puts are in the money at expiration, you will be exercised at the lower strike price and assigned at the higher strike price. The loss will be the strike price difference minus the original credit from the spread. If both puts are out of the money at expiration, both options expire worthless and the profit will be the original credit from the spread. If the stock is between the two strike prices at expiration, you will be assigned at the higher strike price and you will end up with a 100 share long equity position (for every short put owned).

Resistance levels

A resistance level represents a level where a rising stock price tends to reverse and go lower or at least stops going higher. Said otherwise, it is a price level where sellers tend to be more aggressive than buyers which results in a lower stock price. Typically the stock price will back off from this price level on more than one occasion over a period of time to reinforce the notion of resistance. The presumption is that since the security encountered resistance at a given price level in the past, there is a higher likelihood that it will occur at that level again in the future. Therefore, technicians might be inclined to take a bearish position when the price of the security approaches (or hits) a resistance level.  However, if the stock closes above the resistance level then one might consider closing out the position since the reason for establishing the position (resistance will be encountered) is no longer valid.

Resistance level example:

Source: StreetSmart Edge®

Trend line - downtrend

In a downtrend (defined as a series of lower highs and lower lows), technicians might be inclined to take a bearish position when the price of the security approaches (or touches) the trend line.  However, if the stock closes above the trend line then one might consider closing out the position since the reason for establishing the position (the downtrend line should serve as resistance) is no longer valid.

Downtrend example

Source: StreetSmart Edge®

Some potential bearish options strategies to consider if/when XYZ approaches resistance ($37.00) or the downtrend line:

  • Sell-write:  A relatively conservative strategy which involves the short sale of 100 shares of XYZ and the simultaneous sale of a covered put with a strike price and expiration date of your choice. If the stock is below the strike price at expiration, it will be called away and sold at the strike price. If the stock is above the strike price at expiration, the option will expire worthless but the credit received when the (covered) put was sold is yours to keep.
  • Long put: You could purchase one or more puts with a strike price and expiration date of your choice. While it might seem appropriate to purchase a long put with a strike price at the resistance level ($37.00 in this example) or whatever price the downtrend line coincides with, keep in mind that at- and out-of-the-money contracts consist entirely of time value, which means that there is no intrinsic value in the price of the option. This generally indicates that you will need a relatively large move in a short period of time in order to offset the negative impact of time decay. The level of risk involved with this strategy typically depends on the number of contracts purchased along with the specific strike price and expiration of those contract(s). If the stock is below the strike price at expiration, the put(s) can be sold or exercised. If the stock is below the strike price at expiration, the put(s) expires worthless and the loss will be equal to the original cost of the put(s). (Note: the put option(s) can be sold prior to expiration).
  • Bear put spread: You could take a little more of a conservative stance (relative to the long put) by purchasing one or more puts at a given strike price and sell an equal number of puts at a lower strike price with the same expiration. Generally speaking, the level of risk of this strategy depends on the moneyness of the strike prices selected (in-the-money, at-the-money, out-of-the-money) and expiration choice. If both puts are in the money at expiration, you will be exercised at the higher strike price and assigned at the lower strike price. The profit will be the strike price difference minus the original cost of the spread. If both puts are out of the money at expiration, both options expire worthless and the loss will be the original cost of the spread. If the stock is between the two strike prices at expiration, you will be exercised at the higher strike price and you will end up with a 100 share short equity position (for every long put owned).
  • Bear call spread: You could consider selling one or more calls at a given strike price and buying an equal number of calls at a higher strike price with the same expiration. Generally speaking, the level of risk of this strategy depends on the moneyness of the strike prices selected (in-the-money, at-the-money, or out-of-the-money) and expiration choice. If both calls are in the money at expiration, you will be assigned at the lower strike price and exercised at the higher strike price. The loss will be the strike price difference minus the original credit from the spread. If both calls are out of the money at expiration, both options expire worthless and the profit will be the original credit from the spread. If the stock is between the two strike prices at expiration, you will be assigned at the lower strike price and you will end up with a 100 share short equity position (for every short call owned).

Although Schwab does not recommend the use of technical analysis as a sole means of investment research, hopefully this article provided some understanding around how technical analysis might be utilized in regards to options trading. For more information regarding the options strategies above, please visit the Options Trading Paths within the Learning Center on Schwab.com.

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