A powerful combo: Charts and options

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All traders should develop an appreciation of support and resistance: the idea that certain price levels keep their relevance over time as both a bottom and a top for share prices.

These tools are especially useful for our purposes because options have strike prices, and traders often craft strategies around specific levels on the chart.

For instance, they may sell calls at resistance or puts at support. They may use those levels to anticipate the extent a move, letting them increase leverage with a ratio spread. Or they may chose such a price as an entry point when shares have temporarily reversed within the context of a longer-term trend.

MAS "Chart analysis is actually a study of human psychology and the reactions of traders to changing market conditions," John Murphy explain in his classic charting book, "Technical Analysis of the Financial Markets." "There are sound psychological reasons why support and resistance levels can be identified on price charts and why they can be used to help predict market movements."

In other words, people want good entry and exit prices. If they've made money owning a stock, they look for a level to sell and take profits. If they want to own shares, or have profited selling them short, they look for levels to buy. They tend to look back at long-term points where a stock turned in the past, expecting that a constituency of buyers will step in below certain levels or that sellers will appear above other levels.

Perhaps the most common use of support and resistance is the sale of puts and calls. Below are some recent examples we have identified that illustrate these strategies.

SHORT PUTS

  • Core Laboratories has been trending higher and seemed to have long-term support above $70 going back to 2008, prompting a put sale at the $65 strike last month.
  • A similar strategy was seen in Constant Connect after the email-marketing company pulled back from an all-time high.
  • Building supplier Masco bottomed out at $10 over the summer (dark orange line on chart above), prompting a put sale at that level last month.

SHORT CALLS

  • State Street was near a 52-week high in January, pushing against a level that had been support 15 months earlier. One trader accurately expected that resistance would form and sold calls on the lender.
  • TriQuint Semiconductor surged more than 50 percent in late 2010, but then slammed into a level dating back almost a decade. Calls were sold near the peak.
  • Arch Coal fought back to a key level from the 2008 market crash. Traders sold out-of-the-money calls and have profited from the move so far.

As these cases show, there are several ways that investors combine an awareness of support and resistance with the leveraging power of options, significantly increasing the kinds of trades they can implement and while helping them chose strategies with the least risk.

A respect for support and resistance provides clues about where stocks may go, adding a powerful tool for option traders who live and die according to the strike prices on individual contracts.

(Chart courtesy of tradeMONSTER)



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.


This article appears in: Investing , Options

Referenced Stocks: CLB , CTCT , MAS , STT , TQNT

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