Naked Chart Reading and Option Trading

09/18/2009 12:01 am EST

Focus: OPTIONS

If an outsider were to interview any of the Online Trading Academy instructors, he or she would be quite surprised at how similar the mindset of each instructor is when it comes to doing technical analysis. Our students have noticed that all our instructors read naked charts—naked meaning without any technical indicators, such as MACD, Stochastic, RSI, CCI, etc. One of the students even oversimplified the whole thing by stating that "Online Trading Academy is all about support and resistance."

Now, one might ask oneself why would that be the case, when in fact we teach the trading of all four asset classes: Stocks, forex, futures/commodities, and options? The bottom line is that every one of us has gone through a journey of personal evolution when it comes to trading and the use of technical indicators. We have all evolved as technicians from our early trading days. For instance, I was at first drawn to charting by its multiple studying possibilities.

Does It Really Help Your Trading?

When a trader who uses TradeStation, for instance, chooses to insert an indicator, he or she is presented with over 50 choices listed alphabetically. Around early 2000, when there weren't as many as today, I took my time to go through all the existing indicators that my platform had. I took time to do an in-depth study of each of them, one per day. In hindsight, I must say that I became a good mathematician in the process, yet the point is, has it helped my trading?

Not directly. These days, I could tell my students where the moving averages will be even before I plot them on the chart, or what the MACD (Moving Average Convergence Divergence) reading is on the lower studies. Many times, they are truly surprised at first, yet when I explain that all those technical indicators, with the exception of Fibs, are basically lagging indicators deriving their calculations from previous price action or volume, and at rare times the combination of both price and volume to varying degrees, then the mystery becomes somewhat dispelled.

Travel the Whole Circle

In the end, it seems that we had to travel the whole circle starting with simple technical analysis indicators such as moving averages, Bollinger Bands, and Stochastics, and moving on to other various indicators like On Balance Volume (OBV), Relative Strength Indicator (RSI), and Commodity Chanel Index (CCI), to the less well-known such as Linear Regression Variation, Keltner Channels, and inertia to finally realize that none of the technical indicators work all the time.

For instance, moving averages work in either up- or down-trending markets, while in sideways markets, they are useless. There is no single indicator that is going to tell the trader when to enter or exit. It is at that moment of realization that the trader goes back to square one and asks the basic question: "What is the naked chart telling us?"

It is at this very point of origin that we ask ourselves where is the current price action in relationship to its price range (its highs and lows) of the day. Is there a follow through or lack of follow through in the volume readings? Is the current price action creating an outside day, or is the price within the previous day's range?

Having too many technical indicators on the chart would cloud our vision to the point that the trader might suffer from the paralysis of analysis. Overanalysis is seldom helpful. The naked chart is a better choice than the chart with five different (and often conflicting) technical indicators on it.

Black and White

The Stock market is never black and white, but it is rather kind of in between the extremes. At any given time, there could be at least several technical indicators that could give us valid arguments to go long or to go short. Every price action could be interpreted in two different ways. From all the choices given by our platform, a trader could always find a handful that will tell him/her what they want to see, so be aware that more studies could often be counterproductive.

When placing a directional option trade, I side with the more logical side of the two, knowing that within a few moments after my entry, my logic could be proven to be illogical. Options do provide choices beyond the simple closing or opening of a position, and that is exactly the reason why I use options…for choices.

For example, a bear call is a bearish trade built with calls, and if at any given time the trade goes the opposite from what I originally have forecast, it is easy to unwind the position. A bear call is a bearish position built with calls, as I already said, so when the price starts ripping to the upside, the option trader is presented with the choices to (1) either close the whole spread by taking off both legs (bought and sold call) at the same time, or (2) simply close only his or her sold call by buying back his or her obligation while leaving the other call intact.

When to do the follow-up transaction and when not to do it depends on his/her ability to act fast enough and goes back to chart reading skills and depends on his/her directional bias. In either case, trading comes down to basic lines of support and resistance and whether they have been broken with conviction or just punctured with insignificant volume.

In conclusion, the better one gets at his/her ability to read a naked chart, the better he/she will be at directional trading. Options just add an additional edge to the existing choices, which could be used either at the entry or exits.

By Josip Causic of OnlineTradingAcademy.com

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