Many papers and books have been published criticizing the use of technical indicators. These have cited the unreliability of past price behavior, and state preference for pricing models and options-based volatility analysis. One study concluded, for example, that
high derivative rollers who use technical analysis and have speculation as their primary investment objective exhibit the same behavioral traits as investors who favor lottery stocks ⊠technical analysis is associated with greater portfolio concentration, more turnover, less betting on trends, more options trading, a higher ratio of nonsystematic risk to total risk, lower gross and net returns, and lower risk-adjusted returns.1
This paper assumes that options traders relying on technical analysis are interested primarily in speculation. The premise in this book is that chart-based analysis and the use of technical signals is effective for hedging and not for speculation. Consequently, the assumptions in the cited paper might be true for speculative activity and not for hedging activity. It remains a primary point in using underlying technical analysis and charting, that relying on implied volatility (IV) to time options trades is a flawed method and tracking historical volatility (HV) yields a superior and more reliable result for trade timing.
Conventional wisdom views derivatives markets as markets for risk transfer. According to this view, derivatives markets exist to facilitate the transfer of market risk from firms that wish to avoid such risks to others more willing or better suited to manage those risks. The important thing to note in this regard is that derivatives markets do not create new risksâthey just facilitate risk management. Viewed from this perspective, the rapid growth of derivatives markets in recent years simply reflects advances in the technology of risk management.2
This observation raises an issue regarding the hedging attributes of options, as related to an equity portfolio. Not only is hedging a more rational utility of options, it also has progressed as a mechanism for risk management based on the cited advances in technology. Anyone who studies underlying security charts and analyzes price trends with technical indicators is aware of these advances. It makes use of technical analysis of the underlying both practical and effective for hedging activities.
In comparison, there are two flaws in relying on options-specific signals. First, they are artificial and based on unreliable estimates. Second, options value is derived from volatility and price movement in the underlying. This is why options are also termed derivatives. Their value is not independent, and contrary to popular belief, options volatility does not lead price of the underlying. So many myths permeate the options world, and the many âurban legendsâ about how option and underlying behavior are created only make it more difficult to definitively appreciate how this industry works.
When traders abandon the belief in IV and similar analyses favored by the academic world but rarely by the real-world trader, they can turn to charts to gain a sense of how price behavior and related indicators reveal what is likely to occur in options value in the future.
The Key to Profitable Trades
Chartists do not subscribe to a belief that past price trends are reliable to predict the future. They do acknowledge that the pattern and momentum of current price provide indications of what is likely to happen next. The direction of short-term and long-term trends, rate of movement, interim volatility (e.g. characterized by seesaw price patterns or repetitive gaps) and other technical signals reveal the level of market risk to a stock and its options.
It is not accurate to dismiss charting and observation of past price patterns as the sole theory behind technical analysis. Considering the role of options may add to price discovery (determination of an accurate current price of a security) for the underlying, improving both selection of equities and timing of trades:
Empirical evidence suggests that the presence of listed options is associated with higher market quality in the market for the underlying asset. A plausible explanation for this effect is that the presence of a correlated asset permits the sharing of effective price discovery across markets: if market makers in the stock learn from transactions in the option they can set more accurate prices.3
The implication of this evidence is profound. It indicates that technical analysis should not be viewed as an isolated system for âguessingâ future price movement based on past price movement. Rather, technical analysis appears to serve a purpose in the timing of stock trades, and that options play a role in bringing greater order to equity markets.
Price behavior is complex and results from many influences beyond the limited forces of supply and demand. The movement is viewed in charts of an underlying security and volatility itself reflects actual recent price activity. This means that the HV of the security indicates the best (and worst) timing for options trading. The academic focus on IV and models such as the Black-Scholes pricing model is meant to provide a sense of reliability to options pricing, when in fact traders live with uncertainty. Even with the best signals and formulas, IV is an estimate based on assumptions with no basis in fact. Its calculation and outcome rely on the use of an assumed risk-free interest rate. According to NASDAQ, this rate âdescribes return available to an investor in a security somehow guaranteed to produce that return.â4
The rate used usually is a US Treasury rate or a similar rate considered to provide ironclad safety (risk-free), although such a rate cannot exist beyond the realm of theory. However, IVâbecause it is based on assumptions and is intended to forecast future volatilityâis not a reliable estimate of coming option price levels. It is a more rational measure of options pricing in relation to its value in comparison to other options with identical or similar terms.
The rational conclusion is that calculating IV does not provide a reliable, consistent method for profitable trades or for their entry or exit timing. For this, a practical reliance on technical indicators does provide worthwhile data. However, you set up a more dependable system by first selecting companies based on fundamental trends over many years, as a means for narrowing the field of issues on which you will trade options.
The trends discovered in dividends, price/earnings (P/E) ratio annual range, revenues and earnings and debt capitalization are a short list of fundamental trends, but they clearly define how well management controls its fundamental volatility. This is a tendency for financial outcomes to perform in a reliable manner, or to be inconsistent from year to year. Fundamental volatility consistently creates technical volatility in the stock price. A low-volatile fundamental status translates to low-volatility technical status, and high fundamental volatility sets up high technical volatility. The lag time between fundamental and technical outcomes is not consistent, but over many years the relationship clearly can be observed.
Even with the problem of inconsistent lag in the impact of fundamental on technical results, using both makes the most sense. Fundamental analysis yields better long-term results in equity selection, but for options trading, fundamentals do not always impact timing as quickly as technical signals:
[S]tock performance results relying on the fundamental analysis have higher success rate than the models relying on technical analysis data ⊠the variable set produced by means of the technical and the fundamental analyses data [combined] ⊠over performed the averages of separate models based on the fundamental and the technical analyses.5
Once fundamental value has been established, the next step is to analyze the stock of a company on a technical basis. How volatile is the stock price? The HV is based on recent trading range and momentum in the stock price, and as volatility is seen to increase or decrease, you gain a sense of market risk. This in turn is used to decide whether to trade options, and whether to focus on long positions (at times of low HV) or short options (at times of high HV).
Advantageous Price Levels
The status of HV can be thought of as identifying when underlying price levels are advantage for options trading. Options trades should be made according to the price levels of the underlying in relation to the overall trading range. For example, a short call is most advantageous when entered with the underlying price near the top of the trading range. If the price gaps through the trading range, the advantage is at its greatest.
A short put is most advantageous at the opposite level of the trading range. When the underlying price is at a low, timing is ideal for a short put. If price has gapped below support, timing is optimal.
For long options, the opposite proximity is applied. Long calls are best entered when price is at its support level; if price has gapped below support, timing is best. For long puts, the same is true if the underlying price is at resistance. If it ...