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Tuesday, July 2, 2013

Introducing My Technical Analysis Framework For Options Trading.

I remember 10 years ago when I first entered the world of options market making.  Prior to that, I had traded equity index futures and had become pretty proficient with technical analysis.  I remember though instantly losing credibility upon mentioning "technical analysis" in options circles in those days.  I wonder if it is still the case...

Technical analysis, however, is much more than chart pattern reading.  Technical analysis is really THE physical means to perceive what is metaphysical--price, markets, volatility, greed, fear, etc.
In options trading, one must be aware of price behavior or speed and volatility, just as much as price direction.  What better way to do so than through a technical analysis framework that allows one to perceive any market in multiple dimensions.

The first chart lists all the indicators that go into my options trading framework.  The indicators are as follows:

1) Price Dimension
a.      candlestick price chart
b.      log scale in Y-axis
c.      trend lines, trend channels
d.      moving averages
e.      Relative Strength Index

2)      Time Dimension – Intraday, Daily, Weekly, Monthly.  Daily period chosen here.

3)      Volume Dimension – Volume at Price Indicator

4)      Volatility Dimension
a.      Trend/Range Gamma Indicator
b.      Implied Volatility Indicator for Gold futures (if available, in this case $GVX)
c.      Realized Volatility Indicator, my custom method to calculating 30-day historical volatility

5)      Correlation Dimension – Inter market Ratio (Gold to Silver)
 The trading rules are rules-of-thumb but are as follows:

1) Delta - Determine the trend, determine confidence of direction, and determine how much leverage through delta one would want to apply.

2) Gamma - If Trend/Range Gamma (TRG) Indicator crosses above its lower or upper Bollinger band lines or the moving average line, look to see if price breaks above or below a short-term resistance or support.  At this time one would look to be long gamma.  On the flip side, if TRG indicator crosses below its moving average line, one would look to be short gamma.  The confidence of leveraging gamma would be determined by choosing the appropriate expiration dates of options.

3) Vega - If realized volatility indicator and/or an implied volatility indicator are at low end of its 3-month, 6-month, or 1-year ranges AND are starting to rise, then look to be long vega.  On the flip side, if RV or IV is at high end of its 3, 6, 12-month ranges AND are starting to fall, then look to be short vega.  The confidence of leveraging vega would also be determined by relative value of implied volatility to realized volatility, as well as, implied volatility level differences between options with different expiration dates.  To determine this, one would need an effective indicator to calculate "fair value" of future expected volatility.

The second chart explains how all the indicators provide an aggregate picture and means to anticipate future price behavior.

The holy grail in trading (arguably) is not to predict the direction of price in the future but rather be able to determine whether prices would move in a trend or move within a range in the immediate future.  TREND or RANGE?  If we knew this, we could simply switch to and follow buy/sell signals from the appropriate indicators.
TREND or RANGE?  Options traders try to answer this question just as much as stock or futures traders, but in the options world, the language is "long or short gamma".  The third chart shows instances in the market where being long or short gamma using options would have been optimal (at least for gold or GLD).

So why not combine insights from both the directional trading and volatility trading worlds?  Yes, volatility trading may require a more quantitative approach, but I do not see one world as being "better" than the other.  For those traders that follow a more discretionary approach, volatility indicators would provide a way to perceive price along another dimension.  Is not greater awareness just perception through multiple dimensions?

I would highly appreciate feedback.  Is this technical analysis framework for options trading just a compilation of ubiquitous indicators?  Or an insightful methodology to trade options?

Additional content and research can be found in Technical Analysis on Volatility (My Conceptual Framework).

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