Applying Technical Analysis on Option Charts – The Mistakes & Method

But the question is - can the same concept be applied to Option Charts?

A simple answer to this would be ‘NO’. Let’s learn some of the concepts behind Option Pricing to understand this better. Option prices are made up of four components:

Delta (the component of underlying)

Theta (the component of time)

Vega (uncertainty premium)

Gamma (momentum of the delta)

These components will keep affecting the option prices which make it a non-linear instrument.

By applying technical analysis on Option charts what traders are generally accounting for is only Delta (sensitivity to the underlying) whereas other components are equally important and may be more important for few strikes than others.

Let’s learn some common behaviours and challenges in using Option Charts.

Often breaches of supports:

Option prices will have a natural negative slope due to the fact of Theta decay (as time passes by the premium of options will keep eroding). This will lead to supports getting breached more often despite the underlying staying firm.

The theta can affect the option prices significantly in even a short trading span of as low as 2 days. The closer the options are to expiry the more acceleration is evident in theta decay.

In the last week of expiry, options lose their premiums as high as 60% to the theta decay.

Increased Whipsaws:

The component of Vega (i.e. volatility/uncertainty) in option prices leads to large shadows in option prices which may often breach concepts like Moving averages/Trendlines etc.

This movement may not necessarily come from the underlying movement and due to increased uncertainty at times volatility spikes can drift the option prices higher which again cool off once uncertainty is less.

How can we use the beauty of Technical Analysis with Options?

To use the best of both worlds, one of the ways could be to adjust option charts for these Greeks and then apply technical analysis concepts on them but this can be very tedious for traders.

The second way to effectively use the best of them is to draw signals from technical analysis to trade options. Below are some of the common patterns with its implementations:

Short term directional breakout:

If the underlying is breaking out from an important level, the easiest and best in most cases trade would be to participate via. Single options i.e. Long Call / Long Put.

Directional trading for a slower expected movement:

In the cases where traders want to participate an already existing breakout where the movement is slow, getting some compensation of theta is most viable. Strategies like Bull call spread / Bull put spread can be the highest yielding ones with a favourable reward to risk.

Expected consolidation between support/resistance:

When a pattern of technical analysis deals with formations like Triangles, Wedge, etc. the easiest way to trade options are by deploying non-directional strategies like Butterflies, Short Straddles, Short Strangles, etc.

Expected breakout from a Mature Consolidation:

When a pattern of technical analysis is in its last wave, the predictability of a trend coming soon is visible but the direction is not equally confident. In such indications taking a Volatility, the strategy could be beneficial like Long Straddle & Long Strangle.

Summary:

Technical analysis is a great forecasting tool but can be effectively applied to linear assets, applying these to non-linear assets are a breach of concepts.

So either one needs to adjust the non-linear asset for linearity or the most effective way is to draw signals from underlying using Technical Analysis and apply them on options to amplify returns.

Disclaimer: The author is CEO & Head of Research at Quantsapp Private Limited. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.