Archive for August, 2009

Lately traders have asked how I evaluate the major indices and then use that information in my option trading decisions.  The easiest way to explain is to look at the $INDU weekly and daily. Depending on whether you are considering a long term option, a LEAP, perhaps, the weekly chart’s picture will better support your decisions. If you are considering a 3-4 month option, the daily chart will give the most pertinent and timely information, with a quick check to make sure the weekly isn’t making a counter-productive move. If you are workings a short term option strategy, then the 60-minute and daily charts will give the most supportive information.

The more chart reading you do the clearer the picture they paint will be. Chart reading isn’t a 100% perfect vehicle predicting an underlying’s movement, but it puts the odds in your favor. We are going to look at the Dow, but this same process can be used for the S&P, NASDAQ, Russell, and sector indexes.

Let’s look at the $INDU’s charts working from a widing to narrowing view. We’ll start with the weekly:

So how does this chart help in our trading decisions. We might assume based on this chart that the DOW will be range bound, creating the right shoulder for a few more weeks. It is showing signs of being oversold and will probably make a correction or two (perhaps as low as 8,000), before breaking out of this range at 9,500 or so.

If you are considering a trade out to December, this Bullish Head and Shoulders pattern would support that move. One might figure the market could reach 11,500 in that time period. If on the other hand you are considering a trade with expiration in September or October, you may still be bound in its trading range, or working its way up from its lowest levels after a correction. The daily chart will provide more information on the short term movement of this indice.

Okay, so we are narrowing our scope, slipping the chart through the smaller end of the funnel. The indicators seem to indicate that the market is turning upwards and returning to its oversold position and will probably pump its head along the resistence line for a while longer. The general public certainly wants the market to continue its uptrend and it is the retailers (you and I) who are involved in the market at the moment. We want to believe the market will return to its old highs but we are on unsure footing. The news waffles on a daily basis. Better to take small profits while we can. We know this by the low volume levels. August is notoriously known as vacation month, the month fund managers are on their last fling before returning to work in September.  

Beyond what the charts says is likely to happen for the next short period of time, there is a Megaphone pattern that seems to be forming. Often time 2 touches to the bottom and then on the 3rd touch, it breaks through to the downside. A megaphone pattern created from a beginning upward trend is bearish. The reverse pattern is bullish (beginning from a downward trend).

So this megaphone pattern is looming out there and if it is confirmed with a break to the downside, it would test the lines of support on the weekly chart. If they hold at or near 8,000 – 7,500 a turn up would likely be the completion of the Bullish Head and Shoulders pattern on both the weekly and daily charts and the market would slowing work its way back up.

If you have access to minute charts (ex: 60-minute charts), specific entries and exits can be determined using the same process using the lesser time frames on the indice charts, as they support the movement of the day and hour.

Underlying entities can move on their own, based on momentary information (news, PR, earnings), but the majority of its movement is initiated through the support of the market as a whole, its sector and industry ranking. It is far better to have those three working in your favor. 

Go make it a happy day!