Technical trading may sound hard. Heck, I often hear how trading options is hard.
But I’m here to tell you that both couldn’t be easier.
With just three simple steps, you can master the art of technical trading in no time at all.
In fact, in addition to thematic trading, Options Trading Pit uses these tools more often than not — despite market direction.
I’ll give you some examples. . .
Tiffany & Company Upside Profit. . . in a Recession
It was June 2009 when we watched Tiffany & Company (TIF) briefly spike from an oversold $25 to more than $30 — in spite of being knee-deep during the recession.
Those who went long with the underlying stock walked with max gains of 25%.
Those who bought the August 2009 26 call (TIFHZ), for instance, walked with 45% off of the same move.
But here’s something else you may not know: profiting from technical developments has never been easier.
While there are many ways to screen for opportunities, four of my favorites involve the use of Bollinger Bands, W%R, the news, and candlesticks.
By using these four things, we can call for tops and bottoms on indices as well as individual stocks.
Let’s take a look at AIG, for example, from November 2006.
In late November 2006, shares of AIG were grossly overbought.
Technically, once we got word of extremely overbought W%R read (as seen in mid-November), we knew AIG was overdue for a correction. Also notice that at the time, the underlying stock crossed above the upper Bollinger Band with a doji cross, indicating near-term reversal, which we got.
And just as we had hoped, AIG fell from about $72 to less than $69, handing us a quick gain.
However, AIG then bottomed out at $70. Again, technically, we had another doji reversal signal — this time at the bottom of the trend (a doji at the bottom of a trend can be used as a bullish reversal signal).
We bought again at the bottom, marked by an oversold W%R and rode it back from about $69.50 to more than $72 in a few short weeks.
For those of you who aren’t familiar with the terms (doji, Bollinger Band and W%R), check this out:
Dojis usually appear at times of market indecision and have called key reversals in indices and individual stocks.
W%R (or Williams % Range) is the ultimate momentum indicator that signals oversold and overbought conditions. W%R shows an overbought condition with a numerical range read of 0% to 20%. Oversold conditions are measured with a numerical range read of 80% to 100%.
As for Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands. So when prices (in this case, with the Dow) move above the upper Bollinger Band, and are coupled with a bearish candlestick read (gravestone doji, for example), and an extreme overbought W%R read is present, we expect a reversal at the top.
Reverse everything you just learned and you can play bottoms, too.
Using the W%R, the Bollinger Bands, and bearish candlesticks, we called the top of CVS before it sold off from a $36 high on Sept. 12, 2006, to less than $31 two weeks later.
Here’s how we found this:
Step 1: On Sept. 12, 2006, the W%R peaked in overbought territory.
Step 2: On the same day, a bearish doji made its presence known above the upper Bollinger Band.
Step 3: We bought puts and watched as the stock sold off to $31.
Okay, but what’s a doji?
The profit stars, more commonly known as dojis, are commanding reversal signals. These are formed when the candlestick opens and closes at the same level, implying indecision in the stock price.
Depending on the location and length of the shadows, dojis can be categorized into four subcategories:
This candlestick looks like a cross, inverted cross, or plus sign. At the top of a trend, it can indicate that a reversal is near.
Long Legged Doji
Long legged doji formations occur when the stock opens at certain levels, trades in a wide trading range intra-day, and closes at the same level that it opened. These become better predictors when preceded by small candlesticks. Long legged doji formations can imply a change in trend.
The bearish dragonfly doji can usually be found at the market top or during an uptrend. This candlestick tells us the bulls may be losing their way and casts doubt on the market’s ability to continue north. Confirmation is essential. You can confirm with a gap down or a lower close on the following day.
Gravestones are the opposite of dragonflies and indicate top reversals when confirmed with a bearish engulfing scenario (which we also use). These dojis look like gravestones and can signal the death of a stock.
As for the bearish engulfing scenario, an engulfing occurs when a candlestick engulfs the preceding candlestick body.
The Bollinger Bands
For our purposes, let’s make this a bit simpler.
When we use the Bollinger Bands, the closer the market prices move to the upper Bollinger Band, the more the stock market is considered overbought. The closer the prices move to the lower Bollinger Band, the more the stock market is considered oversold.
We’re not going to get into the scientific structures and Bollinger band calculations with each trade. We’d be here until New Year’s 2012 doing that.
Using the Bollinger Bands, look at what happened to CVS (CVS: NYSE) after putting in a doji cross above the upper Bollinger Band. (Note: If a pattern is above the upper Bollinger Band, it’s an extremely overbought condition. We view this as a near-term reversal opportunity.) It sold off from its $36 high (on Sept. 12, 2006), to about $31 two weeks later.
The Williams Percentage Range (W%R)
The third component of the trade is to find an overvalued W%R read, or a chart where the W%R has peaked. According to the W%R, values of 80% to 100% indicate an oversold condition. Values of 0% to 20% are overbought.
Interesting to note: W%R has the ability to anticipate reversals. The indicator will oftentimes peak and turn down days before the stock peaks and turns down. It does the opposite with upside.
In Conclusion. . .
If you’re interested in trading options, print this article. Reference it often.
These are some of the easiest and most important technical indicators out there. Master them, and you can call tops and bottoms with ease.
They’re what we use in Options Trading Pit, along with thematic trading. And we’ve been banking some impressive gains along the way.
Stay tuned for some new research we’re publishing on how we’ll take our newest gains trading options.
Stay Ahead of the Curve,
Ian L. Cooper