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.
"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.
- 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.
- 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
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)