What is the Value of Technical Analysis?

Technical analysis uses history to forecast future price movements and what is likely going to happen in the future. There is no form of analysis that guarantees what is going to happen in the future to a price of a stock, however, technical analysis is used to anticipate what could happen based on previous price history. Technical analysis can be used to assess the following 3 factors:

• Direction - Will the stock move higher/lower?
• Magnitude - How much higher/lower will the stock move
• Timing - How long will a bullish/bearish move last?

Benefits of Technical Analysis

Provides an objective view on price when using a methodological approach. To stay as objective as possible, it is important to stick to the same strategy or indicator used in previous trades. Many traders will change their indicator or strategy based on their bias on a stock. Technical analysis is applicable to all instruments with a price and can be used on all time frames whether it be a 1 minute forex chart or a monthly fixed income chart.

Limitations of Technical Analysis

Strategies may only work in certain market conditions. Some technical strategies will work better in sideways markets, and others work better in trending markets. Traders should analyze whether the strategy implemented was in the right environment. There is no such thing as a best strategy or best indicator. What separates successful traders from the rest isn't what indicator they use, but rather how consistent and methodological their use of an indicator is. One way to implement a consistent methodological approach is to not change indicators based on a bias. For example, if a trader has a bias that XYZ stock is bearish but a 21 period moving average says otherwise, the trader may be tempted to use a 50 period moving average that provides a false confirmation of their own bias. 

Option Strategies for Technical Analysis

Trades generate profits, not technical analysis. Traders tend to spend the majority of the time looking at charts to speculate on the direction of the stock but may place the wrong type of trade. While the direction of the stock is an important factor to consider when placing a trade, the magnitude should also be considered. For example, when analyzing the price of a stock, if there is a:

• Clear direction and unclear magnitude

• Clear direction and clear magnitude 

Price Analysis and Patterns

Support and Resistance lines

Support and resistance lines are areas where price has repeatedly bounced from and moved up (support) or moved down (resistance). As shown in the chart below, price tends to range between support and resistance. This range gives traders a clear sense of direction and magnitude with the support and resistance areas being the target price. In this case, debit spreads would be the best strategy to use. For example, if price has rebounded off resistance and looks like it is heading to support, a good trade would be to buy a in the money put, and sell an out of the money put at the support price. 

In the case where price hesitates around a support or resistance level and the sentiment has changed to a more neutral outlook, credit spreads would be the ideal strategy to use as there is an unclear magnitude. 

Breakouts and Breakdowns

A breakout is when price surpasses a resistance level to rally upwards and a breakdown is when the stock breaks through support. In this case, there is a clear sense of direction as price will likely continue in moving in the same direction after the breakout or breakdown. However, there may not be a clear sense of magnitude, especially in the case when price makes a new 52 week high after a breakout. If there is reason to believe that the stock will continue moving higher after the breakout, simply buying a call or a put would be a good strategy to use. In the case of a breakout where the previous resistance has now become a support level, selling a put credit spread is also a great strategy to use as the trade is profitable as long as the stock is above the new support level. Unlike breakouts, breakdowns usually have a clear sense of direction (down) and clear sense of magnitude as there is a price history. In the case of a fast moving breakdown, buying puts may be the ideal strategy to use. Otherwise, buying debit spreads can also be used. 

Chart Patterns: Reversals and Continuations

When price is at a support or resistance level, there are certain clues and patterns that can tell us whether there will be a reversal or continuation in trend:

• Double top & bottoms: Clear direction and unclear magnitude
  Sell Credit Spreads

• Head & Shoulders: Clear direction and magnitude
  Long Puts, Debit Spreads

• Cup & Handle Reversal: Clear direction and clear magnitude
  Long Calls, Debit Spreads

• Flags & Pennants: Clear direction and clear magnitude
  Buy Debit Spreads

Chart Overlays and Indicators

Lagging Indicators - Moving Averages and Bollinger Bands

These indicators are based on previous price action to help make decisions on what can happen in the future. One popular strategy is the moving average crossover strategy. Moving averages can sometimes act as a dynamic support or resistance level as shown in the chart below. When price moves above a moving average, sentiment may change to bullish for that particular stock (and vice versa). Using the moving average crossover strategy helps give a clear sense of direction but an unclear sense of magnitude as moving averages do not tell the trader how far above or below the moving average line price will go. In this case, credit spreads would be the ideal strategy to use. However, buying longer dated calls and puts can also work well as this gives enough time for the trader to exit the trade in the case of a trend reversal. 

Bollinger Bands on the other hand give a clear sense of direction and magnitude. Bollinger bands is a mean reversal strategy meaning that if the current price moves too far from its average price (which is a moving average), price will tend to retrace back to the mean. When the stock exceeds its Bollinger band, a retracement is usually expected and this gives a clear sense of magnitude as shown below. In this case, buying debit spreads is the best strategy to use. 

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Leading Indicators - MACD, RSI, Stochastics

Leading indicators are used to signal momentum reversals and not magnitude. Leading indicators give a clear sense of direction but unclear sense of magnitude. These indicators are used to show when momentum is speeding up and slowing down - when momentum is overbought and oversold:

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Leading indicators are often misused by traders as sometimes the actual price chart is overlooked. These indicators are better used to confirm the trader's views instead of being the sole instrument in deciding the trend of the stock. For example, if a stock is trading at resistance and a reversal is expected, leading indicators should be used as additional confirmation to short the stock only after looking at the actual price chart. When using leading indicators, selling credit spreads is the best strategy to utilize. This is because that these indicators alone cannot confirm a reversal in price. Even if the RSI shows that the stock is overbought, price may still hover in that area for a long time. Selling credit works best as there is a more neutral sentiment due to the fact that the stock moving much higher is unlikely when it is already overbought. 

Best Practices:

Technical Analysis

• Price is the most important indicator. Use price to determine direction and magnitude
• Indicators should be used to provide confirmation only
• Use fewer indicators to avoid analysis paralysis
• Understand your strategy fundamentally
• Stay consistent with the same strategy

Option Strategies

• Select optimal strategy based on direction and magnitude outlooks
• Understand relationship between risk/reward and probability
• Experiment with different strategies with OptionsPlay

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