Candlesticks and Options: Together at Last

Ah, options. These are not suitable for everyone, but if you are an options trader, there are so many things you can do with them. But more choices can often lead to confusion. How do you decide which strategy to use, which strikes, which expirations? Consider these three ideas to help you in your decision-making process.  

1. Determine Your Directional Bias

Fundamentals. Maybe there was some positive news that could help push prices higher in a sector or stock. Or perhaps the jobs numbers implied a particular sector might get hit hard. Maybe there’s a stock in that sector on your watch list, one you’ve been itching to trade. You think the stock will move down, and you see a trading opportunity. Your directional bias seed has been planted.

Technicals. When should you place the trade? This is when looking at charts may help. Maybe you see a reversal candlestick pattern, such as a bullish engulfing or dark cloud cover, at a key support or resistance level. It’s tempting to place a trade, but you’ll have to decide which strategy to use and how long you want to stay in the position. A bit more analysis may bring you closer to a thoughtful decision. 

2. Take a Historical Look

It can be helpful to go back in time to see if similar patterns have occurred. If so, did price move as expected?  How long did it take for the price movement to reverse? Analyzing chart patterns from this perspective gives you an idea of how long you could anticipate staying in a trade. But anything can happen after you place the trade, so be prepared with exit conditions.

In figure 1, a dark cloud cover formed at a key resistance level (previous high) in late December (purple line). Soon afterward, price retraced to a support level (blue line), and looked like it might reverse to the upside. Would this be a good time to place a trade?

A few observations:

• Go back a few months. In September, price reached a high at the same level (bearish engulfing pattern) and reversed. It took about 12 days from that high to the low.
• Price started trending higher and reached a short-term high in mid-October (dark cloud cover). That took 15 days.
• Price reversed direction and reached a short-term low after 14 days. After that, price trended higher until the December high.
• Since the December high, price retraced and looks to be bouncing off a support level around $126. It’s been 13 days since that high and, based on previous price action, price could reverse. Yet, any negative news could send prices lower.

3. Select Your Strategy

You’ve formed a bullish directional bias, so you could consider buying calls or selling puts. But which strike and expiration should you choose? And how might you hedge your position against a downside move?

Looking at figure 1, if you think price will reverse and move higher, one alternative would be to sell the 122/127 put spread. You’d make some money if the stock moves up, but limit your risk if price moves lower. If you think price will remain in a trading range between the 126 and 138 levels, you could put on an iron condor with strikes around those two levels. Since it takes about 14 days on average from high to low, you could choose expirations at least 30 to 45 days out to potentially capture the move.

There are many ways to approach thoughtful trading. And applying a methodical process can help you find potential opportunities to capture a market’s expected moves. Mapping and planning also reduce the likelihood of staying in a trade that isn’t performing to expectations.

Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

While these principals are the foundation of technical analysis, other approaches, including fundamental analysis, may assert very different views.