The full title of this book is Trading Options: Using Technical Analysis to Design Winning Trades by Greg Harmon.
The book is divided into 5 main parts: (i) market analysis, (ii) sector analysis, (iii) individual stock analysis, (iv) options combinations, and (v) execution tips.
In the first part of the book, Harmon wrote about looking at lots of other markets, as well as ratio charts, to ascertain influences on the main equity indexes. The ironic thing is that for almost every market or ratio, Harmon pointed out that sometimes the correlation is positive, sometimes it is negative. For example, if the price of oil goes up, it can be good for the equity markets; if the price of oil goes down, it can be good too! There is just no stable, reliable relationship that can be drawn. That to me shows the danger of trading based on inter-correlations between markets. Correlations do not give visibility to the underlying variables that drive the correlations, and trading based on the output (i.e. inter-market correlations) of underlying variables can be tricky and dangerous.
The second part of the book wrote about Harmon’s process for reviewing sectors in the market and using technical analysis to rank 9 sectors. It is interesting that he prints out the charts of all 9 sectors, and moves them around physically to rank the 9 sectors.
The third, and the largest chunk of the book, goes into the technical analysis of individual stocks. There are about 80 pages (out of ~220) devoted to this. Harmon covered classic patterns (flag, pennant, diamond, channel, cup and handle, triangle, wedge), candlesticks (hammer/hanging man, engulfing, dark cloud cover/piercing line, stars, three advancing white soldiers/three black crows, rising and falling three methods, doji, spinning top, harami), specific analysis systems (Fibonacci, Harmonics – AB=CD, Bat, Gartley, Crab, Deep Crab, Butterfly, Shark, Three Drives, 5-0, Elliott Wave, Andrews’ Pitchfork), and price-derived indicators (RSI, MACD, BB, MA).
The fourth part explains various common options combinations, and highlights typical scenarios where each option combination would be used. Instead of showing payoff diagrams (there are no payoff diagrams found in the book) which is what a normal options book would do, I find Harmon’s approach of linking options combinations to trading scenarios to be better. Nonetheless, it did get confusing in a few places without some good diagrams to illustrate what the text is saying.
The last section of the book deals with the more operational aspects of options trading: entering, position sizing, hedging, adjustments, etc. I found this section to be somewhat cursory in the treatment of these key subjects, especially on the topic of adjustments when your options positions turn against you. Even though the title of this book is Trading Options, it felt like only one-quarter of the book is specific to options, and only half of that is on the trading of options.
All in all, I find that the main bulk of the book is actually on the top-down analysis of stocks, and using options to express your trading ideas. It may benefit a beginning trader/investor to learn a process and see how an experienced trader expresses his ideas using options, but a more experienced options trader may not get as much out of this book.
OVERALL TREND ANALYSIS
Markets that Inter-relate with U.S. Markets
- Charts reviewed weekly
- Crude Oil
- U.S. Dollar Index
- U.S. Treasury Bonds
- Shanghai Composite Index
- Emerging Markets
- CBOE Volatility Index
- Charts reviewed monthly
- German DAX Index
- Natural Gas
- Japanese market
- The key to any of these influencers is that along with a feel for the direction of the primary trend of the equity indexes, you are watching for externalities that could change that trend quickly.
Important Ratio Charts
- The ratio chart can be interpreted as a visualization of the flow of capital from one market to another…. The trend is the most important aspect of these charts. And even more important than the trend itself is a trend that is starting to change. This is where that portion of the ratio, the potential influencer, needs to be watched most closely for a possible impact to the indexes.
- S&P 500 vs. Emerging Markets
- U.S. Treasuries vs. Junk Bonds
- S&P 500 vs. U.S. Treasuries
- Silver vs. Gold
- Shanghai Composite vs. S&P 500 (XGY0/SPX)
- Sentiment indicators
- Put/Call ratio
- AAII Sentiment Survey
- % of stocks over their 200-day SMA
- Trend tools
- Andrew’s Pitchfork
- Renko charts
- SMA, BB, RSI, MACD, EMA, ATR, MA Envelopes
- One SMA, one oscillator, and one other indicator are enough.
- For use in determining the trend, it is not necessary to change factory-installed settings.
Rank the Nine Sectors and Sort into Leaders/Laggards/In-Betweens
- Technology (XLK)
- Materials (XLB)
- Industrials (XLI)
- Energy (XLE)
- Healthcare (XLV)
- Consumer Discretionary (XLY)
- Financials (XLF)
- Utilities (XLU)
- Consumer Staples (XLP)
- What to look at
- Price in relation to the 50-day SMA
- RSI above / below midline (i.e. 50) or oversold/overbought
- MACD direction, and above / below signal line
- Price pressing or broken Bollinger Band?
- Alternatively plot the returns of all 9 sectors and SPX together in the same chart to see how they compare.
- Pullback after a rise in price is a bull flag, after a fall in price is a bear flag.
- Flags move in the opposite direction of the move into the flag (i.e. the move into the flag is a pullback, the trend then continues out of the flag)
- What you do not want to see is a flag that is rising or falling with the move. These are pennants and are a sign of trend exhaustion.
- Head and Shoulders
- For a H&S top, a flat or falling neckline is more likely to trigger than a neckline that is rising, that is, making higher lows.
- For an Inverse H&S, a flat or rising neckline is expected to trigger with a greater likelihood than a falling neckline.
- You do not know which way it will break until it does.
- A long period of consolidation is a channel, whereas a shorter period is deemed a flag.
- Cup and Handles
- Rounder cups perform better to the upside than sharp V patterns.
- The rounding pattern of the cup shows a change of sentiment from sellers to buyers, with the critical juncture being a retracement from the low point of the cup to the prior high.
- The power of the move is strongest about two-thirds of the way through the triangle. As price moves closer to the apex, the power of the expected move diminishes. Beyond the two-thirds point, it is time to give less focus to the stock and look elsewhere.
- Symmetrical triangles can break either up or down.
- Ascending triangles look more like horizontal resistance. The bottom comes from progressively higher lows. These are presumed to break higher. Descending triangles are presumed to break lower.
- Rising Wedges
- Looks like a symmetrical triangle, except that it is tilted upwards. It can break either up or down, but has a downward bias.
- A falling wedge has a bias for a breakout higher and is considered a bullish pattern.
- When price is basing after a pullback and the RSI is holding the 40 level (not breaking below 40), it indicates that it is a bullish falling wedge rather than a trend down.
- Look for the reversal in the price after an oversold/overbought extreme before placing a trade.
- Bollinger Bands
- Technical signal to enter [for the mean-reversion trade] is the price breaking through a Bollinger band followed by a retracement back inside.
One Way of Setting Stops
- Setting a stop around the 100-day SMA in my experience means you will execute it when the stock has gone three days in a row below the 100-day SMA and is 5% below it.
Always Use Limit Orders with Options
- Using a market order on an option trade can be deadly due to the lack of liquidity. Always use limit orders with options — no exceptions.
Covered Call or Buy Write
- Buy stock, sell OTM call
- Generate income.
Long a Put or Call
- Purpose (Call)
- Low cost way to capture upside
- Purpose (Put)
- Protects against stops not getting filled during short squeezes or gaps
Short a Put or Call
- Purpose (Short Call)
- Generate income.
- Sell naked calls at levels safely above the current price. If needed, hedge by buying the stock before the price reaches the strike price.
- Purpose (Short Put)
- Generate income.
- Sell a strike that is likely to be reached at expiry so as to own the stock at a lower price than today’s price and also lower than the strike price.
Long a Put Spread or Call Spread
- Call spread: Buy a lower strike call, sell a higher strike call, same expiry.
- Put spread: Buy a higher strike put, sell a lower strike put, same expiry.
- Used when the trader wishes to participate in the stock price move after the trigger, but wants to lower the cost of the long call, or there is strong resistance at a level above the trigger.
- The long call’s strike is the trigger price, the short call’s strike is a resistance level.
- The premium from the short call should give at least 25% of the premium paid for the long call, else it is not worth capping the profit in the trade, unless it is a very stable stock with low volatility.
- The cost of the spread should be below one-third of the difference between the strikes.
Short a Put Spread or Call Spread
- Short Call Spread: Sell a lower strike call, buy a higher strike call.
- Short Put Spread: Sell a higher strike put, buy a lower strike put.
- Generate income.
- Compared to an outright sale, limits the risk to the difference between the strikes of the spread, less the premium earned from selling the spread.
- Short put spread can help to lower the cost of a long call, or short call spread can help to lower the cost of a long put.
Long a Ratio Put or Call Spread
- Ratio Put Spread: Buy a higher strike put, sell two (or more) lower strike puts.
- Ratio Call Spread: Buy a lower strike call, sell two (or more) higher strike calls.
- Lowers the cost of the put spread or call spread.
- For a ratio put spread, able to own the stock at a lower price after participating on the downward movement.
- For a ratio call spread, able to sell the stock (you already own) at a higher price after participating in the upward movement.
Long or Short a Calendar
- Call Calendar: Short front month call, long back month call, same strike.
- Put Calendar: Sell front month put, long back month put, same strike.
- Purpose (long call calendar)
- You think that the price of a stock will rise over time, but not too fast, e.g. when the market seems to be pausing within the current trend.
- A short call in the near month can lower the cost of the outer month call. Strike is chosen to reflect the potential resistance areas overhead with an understanding of the time until expiry as well.
- If the near month call ends up ITM at expiry, closing the spread will usually be profitable. This is because the short call will trade at its intrinsic value, and the long call will trade at intrinsic value + time value. However if the price is materially above the strike, the time value can be closer to zero.
- Purpose (short call calendar)
- Generates a credit.
- Earns premium from being short the longer call, but looking for protection int he near term against a strong move higher by also buying a cheap front-month call.
- Purpose (short put calendar)
- You think that there is short-term risk to the downside, but that the price will close above the strike at the back month expiry.
- If that spike down does come, and traders expect a reversal higher, they can sell the front month put and keep the back month short put.
- Can be used to fund a long call calendar when there is a stock that looks like it could have great upside potential but may at risk for downside in the short run.
Long or Short a Diagonal
- Long Call Diagonal: Long call, short call at a higher strike in a longer-dated expiry
- Long Put Diagonal: Long near-dated put, short an outer month put at a lower strike.
- You see that the stock is in a resistance zone or there is one nearby above that may take some time to work through. This can give added confidence to sell a lower strike call than you would with a trending stock, where you would use a Calendar instead.
- Short call Diagonals can often be entered for a credit, as the near month that you are selling is usually worth more than the outer month you are buying.
- Traders would choose a long put diagonal over a put spread with the same strikes if they do not want their profits capped on a move lower in the short run and think the stock will recover, or if they think that the support will hold for a long time so then can lower their cost of entry in the whole trade.
- Traders would choose a long put diagonal over a put Calendar if they think it may take a lot of time for a recovery to happen in the stock price once its falling.
Long or Short a Butterfly
- Long Call Butterfly: Three strikes, sell 2 of middle strike calls, buy 1 lower strike call, buy 1 higher strike call, all having the same expiry. Equivalent to being long a call spread with the lower two strikes, and short a call spread with the higher two strikes.
- Long Put Butterfly: Buy 1 lowest strike put, buy 1 highest strike put, and sell 2 of the middle strike puts.
- The middle strike should be chosen based on an expected support or resistance level in a trend, options open interest, or other patterns. If there is confluence of support from a Fibonacci level and a traditional pattern target, that also coincides with large (in a relative sense) open interest in the options for that expiry, you have a great middle strike for your put Butterfly.
- If a stock is trading in a channel that is above a gap (i.e. there is an ‘island’), selling Butterfly with all 3 strikes within the gap would express the view that the island holds up, but that if it does not, a move below the lowest strike is likely, to close the open gap.
Long or Short a Straddle
- Long Straddle: Buy put and call with same strike for same expiry.
- Lets you trade without a view. Participate in a move out of a consolidation zone.
- One way is to long the Straddle with the strike set as the middle of the consolidation range. Another way to play the same channel is when price reaches the top or bottom of the channel, play for either a breakout above the channel or a failure and pullback toward the bottom of the channel by buying with the strike = top of channel.
- Long Straddle is most useful when a stock is moving in a very tight channel for a long time, there are big gaps until support and resistance above and below the current price, and the Straddle is priced at what seems like a cheap implied move in the stock by expiry.
- Short Straddle is most useful when a stock is trading in a range for some time with support and resistance tight to the range, and the implied move in the Straddle would take the stock well outside of that support and resistance.
- [My note: implied move of the stock = cost of the straddle, e.g. if the straddle costs $10, breakeven in the straddle is when the stock moves up $10 or down $10; since a $10 move would mean that both buyer and seller breakeven, using a $10 move as a valuation assumption will give you the fair value of the straddle, which is $10. Hence a $10 fair value implies a $10 move in the stock by expiry.]
Long or Short a Strangle
- Long Strangle: Buy put and call with different strikes for same expiry.
- Cheaper way to trade for a channel break either way, but the trader does not participate in profits until the stock has moved beyond the range of the Strangle by the premium paid.
- If the channel or anticipated move from the technical analysis is wide, a short Strangle is preferred as it has some initial protection if inertia takes hold.
- If traders think that a stock might take some time to break out, they might sell a Straddle or Strangle in the near month and buy the Straddle or Strangle in an outer month. This is equivalent to going long both a call Calendar and a put Calendar.
Long or Short an Iron Condor
- Long: Buy call spread and put spread for same expiry.
- Short: Short call spread and short put spread.
- Expect stock to remain in a tight range.
- When you expect a large move in a stock either way and want to pick up a piece of the move, but not near the beginning of it, you can go long a Strangle a bit away from the current price and then short a Strangle outside it.
- If a trader believes a stock will go up or down and enters a long Straddle, he may sell a wide Strangle to lower the cost, thereby creating an Iron Condor.
Long or Short a Risk Reversal
- Bullish Risk Reversal: Long call and short put, usually same expiry.
- Bearish Risk Reversal: Long put and short call, usually same expiry.
- The bullish Risk Reversal is a one-directional bet, up.
- A bearish Risk Reversal paired with a long stock position is called a Collar. Often the call has a later expiry than the put so as to have enough value to get the put for free, or retain a credit.
- Often used when the stock is in a strong trend with no signs of exhaustion or when a stock is reversing trends.
- If there is strong overhead resistance, traders can sell a call near that resistance to lower the cost, effectively this means that the long option in the Risk Reversal is a spread. A call spread Risk Reversal, also called a Seagull, has the same characteristics as the bullish Risk Reversal, except that the upside profit potential is capped by the short higher strike calls.
Elements of an Option Trade
- Choose the driver — the one option that is used to drive the profitability of the trade. It is the call or put option that you want to be long or short no matter what else is going on in the trade.
- Choose the funding options — options that lower or fund the cost of the trade. You want to create a minimum 3:1 reward-to-risk ratio.
- Choose a risk limiter if necessary — assess the risk remaining in the trade, and put on components that will to limit risk if necessary.
- How much you are willing to lose on any given trade?
- What time frame do you trade? longer term = wide stop = smaller size
- Where are the technical triggers to enter and exit? wider loss potential = smaller size
- What is your trading size vs. the daily volume?
- Limit long stock positions to 7.5% of portfolio capital.
- Limit margin usage on short stock positions to 7.5% of capital.
- Limit premiums paid on long options and debit options combinations (spreads, Calendars, Butterflies, etc.) to 2% of capital.
- Limit margin usage to no more than 7.5% of portfolio capital on short options positions (sold options, credit spreads, etc.). This is estimated by assuming 10% of the short strike as margin.
- Limit options to no more than 100 contracts where liquidity and other rules allow.
- Never have a position that is more than 5% of the recent average daily volume.
Don’t Trade in the Opening Minutes of the Day
- The pent-up demand can create a frenzy the first 30 to 60 minutes on Monday, and to a lesser extend, 30 minutes or so, at the start of every other day of the week. Often the moves in this time period do not hold.
- There are 3 exceptions: (i) if I am taking a profit, (ii) if I am looking to day trade a stock, (iii) if the stock had triggered and failed the previous day, but triggered again during the opening today.
How to Enter the Trade
- Now that it is 10:30 or so, the waters will have cleared and it is time to wait for your triggers. If a stock has triggered in the opening period and has held up, with a sideways consolidation or a pullback to the trigger and then reversed again, you can trade it right away.
- If it triggered and failed, then keep an eye on it for the next trigger to enter.
- For a long trade, you can bid on the offer side of the market for the full size of your trade if it is small compared to the offer size. Use a limit order.
- Immediately place a stop loss. Your trading system will need to have conditional stops allowing you to stop the options trade on a trigger in the stock price.
How to Hedge
- Hedging protects the current position, it can be applied to protecting profits as well as preventing further loss.
- Sometimes you may be in an options position that moves in the after-hours market, then you may need to use stock.
- If you are net long, hedging by selling stock short is the best way to go. For the opposite, if you are in a short position, then you will need to buy stock to hedge.
- Using options for an outer month concentrates any move in the stock to the price movement and less to changes in volatility and to changes in time to expiry.
- The hedge should be taken off when the price is finished moving against you. Use technical analysis on a shorter intraday time frame to discover when this is happening. When the trend has changed on the shorter time scale, then it is time to take it off.
How to Take Profit
- Don’t let a winning trade turn into a loser because it did not reach your profit target.
- Use the stops but also continue to watch the chart. If the stock turns (look at candlesticks, RSI, MACD, etc.), go ahead and sell some of your position to take profits.
How to Make Trade Adjustments
- Say you are long a stock, and it moves against you but did not trigger your stop. One of my favorite adjustments to a stock that is in the hole but looks headed higher is a 1 x 2 call spread. This can be looked at as adding a covered call to the stock trade, and a call spread alongside.
- These types of adjustments are often available for free or even a small credit sometimes. Of course if the stock does not move or falls they are worth nothing, so it is important not to pay much for them.
- Real trading is lots of work and planning followed by patience to sit around and wait for a trigger, so that you can enter a trade and immediately look to adjust the plan that took you so long to create. You need to be open to exploring the technical setup constantly to be able to adjust and take advantage of the new situation.