An Option Indicator That Speaks Volumes

04/27/2012 7:00 am EST

Focus: OPTIONS

Alan Ellman of The Blue Collar Investor cites recent volume action in three stocks that illustrates how watching volume patterns can give option traders critical signals and even predict upcoming price swings.

When learning how to trade options, volume must always be factored in. Volume is the number of shares or contracts that trade over a specific period of time, usually one day. On a chart, volume is represented as a histogram (vertical bars) overlaid on or below the price chart.

This indicator is an essential part of every technical formation, as a price pattern will typically have a volume pattern attached to it. In other words, we use it to confirm trends and chart patterns. If a stock is truly in an uptrend, we would expect the volume to also be in a similar pattern. This will increase the chances of the trend continuing.

Any price movement up or down with relatively high volume is seen as stronger and more reliable than a similar move on weak volume. The same guideline holds for changes in the MACD and stochastic oscillators. If we see positive or negative signals in these indicators, they are more significant on high volume and less so on low volume.

Some chartists will draw a trend line on volume and compare it to the trends of price and other technical indicators. If they are not moving in the same direction, we have a negative volume divergence.

For example, if price is rising and volume is declining, there could be a trend reversal on the horizon. On the other hand, if price is declining and volume is accelerating, this negative trend is confirmed and a sell signal is more meaningful. Such an example can be found in the below chart of Marvell Technology Group (MRVL):

chart
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  • The red arrows highlight strengthening volume
  • The blue arrows show a declining price trend
  • Volume is also confirming a negative MACD divergence (green circles)
  • Volume is also confirming a negative stochastic oscillator divergence (red circles)

In the below chart of Guess (GES), we have an example of a negative volume divergence demonstrating a potential trend reversal:

chart
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  • Red arrows highlight volume confirmation of price acceleration
  • Blue lines show weakening volume and price consolidation (sideways pattern)
  • The green arrow shows a severe price reversal with volume confirmation (green circle), as the volume bars are much higher than during consolidation

Technicians who look for specific chart patterns such as triangles, flags, and head-and-shoulders patterns can also utilize volume patterns to confirm the accuracy of these patterns.

Another important concept in technical analysis is that volume precedes price. If volume is weakening during an uptrend, it is often times a signal that the trend is about to reverse.

NEXT: Another Strong Example of Volume in Action

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Now, we’ll put it all together with an example using F5 Networks (FFIV).

At the start of the March contracts, I bought FFIV at $125.56. Although the chart pattern was still bullish, the confirming technicals were turning bearish. In addition, volume was declining, indicating a possible trend reversal.

In situations like this, I will often write in-the-money (ITM) strikes and allow the option buyer to “pay for” an insurance policy in case the price begins to trend down. I sold the March 120s for $8.62 for a 2.6%, one-month return with downside protection of that profit of 4.4%.

On March 1, the 120 call was trading at parity (all intrinsic value) as the stock approached $128, so I closed my total covered call position and used the cash to open a new position with a different stock.

As it turned out, I didn’t need the downside protection, but the decision I made initially was based on sound fundamental, technical, and common-sense principles, and I still found a way to enhance my already maximized returns. Here is the chart of FFIV as of March 2:

chart
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Conclusion
Volume is an essential technical tool that will verify the significance of a price pattern or technical analysis indicator confirmation or divergence. It can also be predictive of upcoming changes in chart patterns.

We use volume to corroborate buy/sell signals. A positive or negative signal on high volume is much more significant than one on low volume. Volume surges (1.5 times normal volume) are especially significant.

By Alan Ellman of The Blue Collar Investor

What indicators do you use to trade options? Share your thoughts in the Comments section below.

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