Technical Analysis for Options Traders

There exist today an array of charts, patterns and statistical analyses for use in Options Trading by Options Traders. Though it often looks and reads much like mathematical tea-leaf reading, most of the commonly used tools are based on serious empirical studies of the markets.

The best way to explain what technical analysis is may be to contrast it with its arch-rival and sometimes partner: Fundamental Analysis.

Fundamental analysis consists of attempting to evaluate a financial instrument (a stock, bond, etc) by looking at factors affecting intrinsic worth. Company earnings, basic industry conditions - everything from the overall economy to who sits in the Chief Financial Officer's chair.

Technical analysis shuns measurements of such things as assets and liabilities and focuses less on company or industry specifics. It looks instead for statistical patterns among historical (both recent and long term) price movements, volume and a large number of other variables.

Some of these variables and patterns appear arcane to all but the specialists. Fortunately there are a few basic ones available to the savvy but still mere mortal.

One of the most basic is the simple bar chart. In use for centuries in one form or another, it consists of the familiar vertical stick with small horizontal tick marks attached.

The length of the bar shows the price range of the instrument for a recent period - usually the last 24 hours or the trading day up to that point. The horizontal mark on the right indicates the opening price, the left-pointing one shows the closing price.

A series of these laid out across a chart - for periods of a week, a month, quarterly, etc - forms a pattern. It's that pattern that the technical analyst uses (in part) to predict how the pattern will continue - i.e. what the price will be an hour or a day or a few weeks hence.

Traders who rely heavily on technical analysis are rarely long term players. Somewhat like predicting the rain, a set of data can help you guess with high probability what will happen in the short term. It's less useful for judging the outcome three months ahead.

Japanese Candlesticks - adapted from the Japanese, where they were used to forecast rice futures - are a common variation. The change consists essentially of 'fattening' the vertical stick and adding color to indicate variations between opening and closing prices.

Red strips are used to show a closing price lower than the previous period, green when the instrument closed higher. Again, different shapes suggest - to the initiated - different market movements.

Since options, like bonds, add the element of time expiration new variables to predict patterns come into play. Also, since as a derivative an option has no intrinsic worth, price and volume changes can (and do) occur as a result of changes to the underlying asset.

Some of the variables that measure these changes make their way into technical analysis charts.

Delta, for example, measures how much an option price rises or falls relative to the change in price of the underlying asset. Theta measures how much an options position gains or loses in a period of time - a day, a week, a month, etc.  Vega is a measure of how much a position gains or loses as volatility changes by a specified percentage.

Fortunately, there are trading software packages available that will allow tracking of these and other variables. Algorithms are built in that experts assert indicate thresholds and patterns that signal buy or sell.

Since there are dozens of such offerings, containing hundreds of different variables and patterns, only experience can teach you which are meaningful and which mere numerology.