Technical Analysis and Options Strategies for Long-Term Position Traders

By Ken Shaleen
November 2005

The age-old question all traders face is when to enter a new position. There are three obvious choices for classical chartists: in anticipation of a breakout, on the breakout (a close outside the formation), and after a price pullback toward the breakout.

You might see a pattern unfolding and want to "lead off," or get into a trade before it actually develops. This can be a mistake—what if the breakout you are anticipating doesn't happen? But on the other hand, you don't want to miss out on the trade, or get in too late. You can use an options strategy to help you in this situation.

As you see the evolution of a price pattern, specific options strategies may be far more suitable for establishing a position than an outright long or short trade. This is especially true in the futures markets, with their propensity to gap open beyond reasonably placed protective stop-loss orders.

Let's examine a classic head-and-shoulders bottom pattern as an example of a chart that offers potential for an upside market breakout. A head-and-shoulders chart formation resembles a human head and shoulders and is generally considered to be predictive of a price reversal. A head-and-shoulders top (which is considered predictive of a price decline) consists of a high price, a decline to the support level, a rally to a higher price than the previous high price, a second decline to the support level, and a weaker rally to about the level of the first high price. The reverse (upside down) formation is called a head-and-shoulders bottom (which is predictive of a price rally).

Any head-and-shoulders pattern needs five reversals of the minor price trend. In a head-and-shoulders bottom, the lows at points one and five are the low of the shoulders. There must be a high-volume close above the neckline to confirm a bullish pattern. Once that pattern is activated, you can calculate your upside objective. The problem is, when we think we have a low on the right shoulder, we get excited about putting on a position, that is, getting long. But if we put that position on too soon, that would be anticipating the breakout, which might or might not occur. We need to wait for a close, until the pattern is fully formed. What we can do in anticipation of this pattern, however, is to use an options strategy.

The Vertical Bull Call Spread

To anticipate an upside breakout with a limited loss potential (but also a limited reward potential) you can initiate a vertical bull call spread. You would buy the lower strike price and sell the higher strike price of the same expiration month. Conversely, if you see a possible head-and-shoulders top forming and expect the market to fall somewhat, you'd initiate the opposite lead-off options strategy—a vertical bear put spread where you'd buy the higher strike price and sell the lower of the same expiration month. See chart.

 

The options strategy is a debit transaction, with your breakeven point the lower strike plus your net debit. Your maximum profit equals the higher strike minus the lower strike minus the net debit. If you are willing to consider a lower possible reward (versus an outright long in the underlying instrument), the advantage of this strategy lies in the fact that your maximum loss is equal to your net debit. That is, you are only risking the funds you need to initiate the position.

So, which call to sell and which to buy? I would recommend being long the at-the-money option and short the out-of-the-money. This is in anticipation of buying back one-half of the higher strike on the breakout.

If the market is trading at 100, you'd be long the 100 call and short the 102, or for a more aggressive approach, short at 104. This is more aggressive because the maximum reward is only realized (assuming no lifting of legs) if the underlying instrument is trading above the upper strike (at expiration). If you look at the diagram, the letter "C" on the chart would be the at-the-money option, say at 100, while the "A" strike would be out-of-the-money 96 and the "E" the in-the-money at 104.

You can go back to your head-and-shoulders chart pattern to find out what strikes you might want to use, based on your projected breakout target. This is shown on the diagram by moving the vertical distance of the pattern over to the price at the neckline break.

Keep in mind, objectives for head-and-shoulders patterns are minimums; the breakout could exceed your expectations. A wise strategy is to take profits you might realize on one-half of your position, then let the rest ride until the charts tell you the outlook has changed. Look at open interest for clues also; see where it's concentrated. And use a trailing "mental" stop on the price chart of the underlying instrument to help you lock in any gains.

A benefit to this type of long-term approach to trading is that unlike a short-term trader, you don't have to be glued to your screen all day, and you don't need to pay for real-time quotes.

This is just one strategy you can consider when using technical analysis. There are many more options strategies you can incorporate depending on your viewpoint, the type of chart pattern you see, and at what stage the pattern appears to be.

If you are interested in this or other options strategies, please speak to one of our Lind Plus brokers, who would be happy to assist you.

Ken Shaleen is President of CHARTWATCH and a frequent instructor at CME. To find out more about Ken's weekly technical research, go to www.chartwatch.com, or visit the CME's Web site at www.cme.com for Ken's upcoming classes, and others.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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