In this blog post, I will describe how I use technical analysis to determine entry points for new option trades, adjustments for existing trades, and rules for closing positions.
This is in addition to the groundwork I do for selecting the right underlyings for option trades based on volume, open interest, option greeks, etc.
There are thousands of indicators, and especially in the beginning, I wanted to use them all. But the goal is to limit the number of indicators you use . And then to really get to know them.
Also, I make sure that the indicators I use are not directly related to one another. For example, a momentum indicator might complement a volume indicator successfully, but two momentum indicators aren’t better than one.
The main indicators I use are:
- Bollinger Bands in combination with Keltner Channels
- ATR and Expected Move
- Resistance/support areas and linear regression trends
- Finally, I want to know whether there’s material news, an event upcoming like dividends or earnings dates.
All combined determine my option trading’s decisions.
Table of Contents
- Bollinger Bands and Keltner Channels: Trends and Volatility
- Average True Range (ATR) and Expected Move: Volatility
- Average Directional Movement Index (ADX/DMI): Strength Trend and Price Direction
- Relative Strength Index: Price Momentum
- Resistance/Support Areas and Linear Regression Trends
[Block also used in journal]
Bollinger Bands and Keltner Channels: Trends and Volatility
My first trade selection criterium is whether the Bollinger Bands are outside the Keltner Channels.
The second criterium is whether the price just bounced back down after touching or pearcing the upper Bollinger Band, or the price went up again after reaching or going through the lower Bollinger Band.
I also need to see an opposite red candle showing me the price is bouncing back down, or an opposite green candle for the price going up again.
Then I (have to) combine this information with the signals I get from indicators for momentum, volatility, relative strength, regression trends and resistance/support areas etc. to determine what to do.
The Bollinger Bands just being outside the Keltner Channel or the price reaching the lower or uppoer band is NOT as such a signal to buy or sell.
BOLLINGER BANDS (BB) combined with KELTNER CHANNELS (KC)
BB outside KC
Are the Bollinger Bands outside the Keltner Channels?
If not: no entry
Price touched upper or lower BB and went down/up ?
If not: no entry
There is an opposite red (upper BB ) or green (lower BB) candle proving price is down/up ?
If not: no entry
Are KC within BB?
Are Keltner Channels within the Bollinger Bands?
If not: no entry
Price went through upper or lower KC when going up/down ?
If not: no entry
KC angle direction
In which direction is the KC moving?
A rising channel means the price is rising, while a falling/sideways means falling or moving sideways price?
Is ATR rising or falling?
A rising ATR means the volatility is rising, while a falling/sideways means falling ATR?
Bollinger Bands is a technical analysis tool defined by a set of trendlines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of an underlying’s price.
I compare price action and Bollinger Band action to arrive at buy and sell decisions based on overbought/oversold conditions (source and for more rules: www.bollingerbands.com):
- By definition, price is high at the upper Bollinger band and low at the lower band.
- Bollinger Bands can be used in pattern recognition to define/clarify pure price patterns such as “M” tops and “W” bottoms, momentum shifts, etc.
- In trending markets, price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.
- Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.)
- Bandwidth has many uses. Its most popular use is to identify “The Squeeze”, but is also useful in identifying trend changes.
Approximately 95% of price action occurs between the two bands. Any breakout above or below the bands is a major event. But it is not a trading signal to buy or sell. For the direction and extent of future price movement you need the other indicators (e.g. Keltner Channels, DMI, RSI, regressions trends, MACD, on balance volume).
I can adjust the SMA and standard deviation assumptions and monitor them.
Understanding Bollinger Bands
- There are three lines that compose Bollinger Bands: A simple moving average (middle band) and an upper and lower band.
- The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average (SMA) which is the center line, but they can be modified.
- The SMA averages out the closing prices for the first 20 days.
- The standard deviations measure how spread out numbers are from an average value. Those produce the upper and lower bands.
- Standard deviation is a measure of volatility, when the markets become more volatile the bands widen; during less volatile periods, the bands contract.
- When the price continually touches the upper Bollinger Band, it can indicate an overbought signal while continually touching the lower band indicates an oversold signal.
The “squeeze” is the central concept of Bollinger Bands. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities.
Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or in which direction the price could move.
Keltner Channels are volatility-based bands that are placed on either side of an asset’s price.
The Keltner Channel is a volatility-based technical indicator composed of three separate lines. The middle line is an exponential moving average (EMA) of the price. Additional lines are placed above and below the EMA. The upper band is typically set two times the ATR above the EMA, and the lower band is typically set two times the ATR below the EMA. The bands expand and contract as volatility (measured by ATR) expands and contracts and can aid in determining the direction of a trend
The Keltner channel uses the average-true range (ATR) or volatility, with breaks above or below the top and bottom barriers signaling a ‘continuation’ (an indication that the price of a stock or other asset will continue to move in the same direction even after the continuation pattern completes.)
This indicator is most useful in strongly trending markets when the price is making higher highs and higher lows for an uptrend, or lower highs and lower lows for a downtrend.
I can adjust the EMA, ATR and standard deviation assumptions and monitor them.
Main source: Investopedia
While Keltner Channels can help identify trend direction, and even provide some trade signals, they are best used in conjunction with price action analysis, and other technical indicators. KC may also not act as support or resistance.
Understanding Keltner Channels
- The exponential moving average (EMA) of a Keltner Channel is typically 20 periods, although this can be adjusted if desired (in line with Bollinger Bands SMA).
- The upper and lower bands are typically set two times the average true range (ATR) above and below the EMA, although the multiplier can also be adjusted based on personal preference.
- Price reaching the upper Keltner Channel band is bullish, while reaching the lower band is bearish.
- The angle of the Keltner Channel also aids in identifying the trend direction. A rising channel means the price has been rising, while a falling or sideways channel indicates the price has been falling or moving sideways, respectively.
- The price may also oscillate between the upper and lower Keltner Channel bands, which can be interpreted as resistance and support levels. They may look to buy when the price reaches the lower band and then starts to move higher again and may look to sell or short after the price starts to fall again after reaching the upper band.
- Since most price action will be encompassed within the upper and lower bands (the channel), moves outside the channel can signal trend changes or an acceleration of the trend.
- A price move above the upper band shows price strength. This is another indication that an uptrend is in play, especially if the channel is angled upwards.
- A drop below the lower band shows price weakness. This is evidence of a downtrend, especially if the channel is angled downward.
- If the price is continually hitting the upper band, but not the lower, when the price does finally reach the lower band it could be a sign that the uptrend is losing momentum.
- If the price is constantly hitting the lower band, but not the upper, when the price does finally reach the upper band it could be a signal that the downtrend is near an end.
- After a sideways period, if the price breaks above or below the channel and the channel starts to angle the same way, that may signal that a new trend is underway in that breakout direction.
- If the price action breaks above the band, the trader should consider initiating long positions while liquidating short positions. If the price action breaks below the band, the trader should consider initiating short positions while exiting long or buy positions.
Keltner Channels vs. Bollinger Bands
The two indicators are quite similar:
- Keltner Channels use ATR to calculate the upper and lower bands
- Bollinger Bands use standard deviation instead.
The interpretation of the indicators is similar, although since the calculations are different the two indicators may provide slightly different information or trade signals.
So why do I still use them both, whereas the in dicators seems somewhat related to each other?
They produce different signals. Like Bollinger Bands, Keltner Channel signals are produced when the price action breaks above or below the channel bands. Here, however, as the price action breaks above or below the top and bottom KC barriers, a continuation is favored over a retracement back to the median or opposite barrier.
The Bollinger Bands Keltner Channel Strategy
Every time the price reaches one of the Bollinger Bands, a contrarian position is most suited and this is evidenced by the reactions we tend to see when prices hit the extremes.
So, whenever an underlying reaches the upper Bollinger Band, we can say that statistically, it should consolidate and when it reaches the lower BB, we can say that statistically, it should bounce.
What would we get if we combine the Bollinger Bands and the Keltner Channel signals?
The BB/KC strategy is then:
- Go long (buy) whenever the market price is below its lower 20-period Bollinger Band and below its lower 10-period Keltner Channel. Hold this position until getting another signal or getting stopped out by the risk management algorithm.
- Go short (sell) whenever the market price is above its upper 20-period Bollinger Band and above its upper 10-period Keltner Channel. Hold this position until getting another signal or getting stopped out by the risk management algorithm.
- The standard deviation used on the Bollinger Bands is by default 2.0 and the multiplier used on the Keltner Channel is also by default 2.0.
As such the strartegy only aids in determing the right entry, adjustment to closing points. On its own, as backtesting has shown, it doesn’t guarantee a higher probability of winning trades. It needs to be seen in combination with other indicators and depends very much on my risk managament method.
Therefore, I also look at other technical indicators like regression trensds, DMI, RSI and option-related data like on balance volume, open interest, option greeks.
Average True Range (ATR) and Expected Move: Volatility
Knowing how much a stock’s price is expected to fluctuate over various time periods can give you a reasonable expectation for an underlying’s future prices. Additionally, if you want to calculate an expected range over a specific period of time, you have the ability to do so.
ATR in General
The ATR(14) is a measure of the price movement of the underlying security over the past 14 trading days. The ATR(14) is expressed in both dollars and cents and as a percentage of the underlying equity’s price. When low, it’s unlikely to have attractive premium values. You can see this by examining the Mark (“market”) values for each strike price of the underlying option.
The Keltner Channel indicator uses Average True Range (ATR). I also use ATR to determine my ‘point of no return’ of a trade (to be explained in another post).
But what is the Average True Range or ATR?
The ATR is a technical analysis indicator that measures market volatility by decomposing the entire range of an asset price for a specific period.
The true range indicator is taken as the greatest of the following:
- High – Low: current high less the current low;
- High- Previous Close: the absolute value of the current high less the previous close;
- Previous Close – Low: the absolute value of the current low less the previous close.
Once we have got the maximum out of the above three, we simply take a smoothed average of n periods of the true ranges to get the Average True Range.
The ATR is then a moving average, generally using 14 days, of the true ranges. Daily is typically the period used.
Although it is considered as a lagging indicator, it gives some insights as to where volatility is now and where has it been last period (day, week, month, etc.).
Traders can use shorter periods than 14 days to generate more trading signals, while longer periods have a higher probability to generate fewer trading signals.
I use TradingView where the ATR is a Relative Moving Average (RMA) of the True Range, but I can change the smoothing type to SMA, EMA or WMA in the settings.
ATR is an indicator which is best used as a compliment to more price direction driven indicators. Once a move has begun, the ATR can add a level of confidence (or lack there of) in that move which can be rather beneficial.
- It is a metric used to measure volatility, especially volatility caused by price gaps or limit moves.
- ATR is most useful in measuring the strength of a move. For example, if a security’s price makes a move or reversal, either Bullish or Bearish, there will usually be an increase in volatility. In that case, the ATR will be on the rise. This can be used as a way to gauge the underlying strength of the move. The more volatility in a large move, the more interest or pressure there is reinforcing that move.
- The indicator does not indicate the price direction; rather it is used primarily to measure volatility caused by gaps and limit up or down moves.
- A stock experiencing a high level of volatility has a higher ATR, and a low volatility stock has a lower ATR.
- The ATR may be used to enter and exit trades, and is a useful tool to add to a trading system.
- It is commonly used as an exit method that can be applied no matter how the entry decision is made. For example for the “chandelier exit”: placing a trailing stop under the highest high the stock reached since you entered the trade. The distance between the highest high and the stop level is defined as some multiple times the ATR. For example, we can subtract three times the value of the ATR from the highest high since we entered the trade.
- The ATR can also give a trader an approach to position sizing that accounts for an individual trader’s own willingness to accept risk as well as the volatility of the underlying market.
- Whenever a price closes more than an ATR above the most recent close a change in volatility has occurred.
Also ATR has limitations. ATR readings are subjective and should always be compared against earlier readings to get a feel of a trend’s strength or weakness.
It is calculated using absolute values of differences in price which means that securities with higher price values will inherently have higher ATR values.
The consequence is that a trader cannot compare the ATR values of multiple securities. What is considered to be a high ATR value or a high ATR range for one underlying may not be the same for another underlying. I need to analyse each ATR per underlying on case-by-case basis.
ATR only measures volatility and not the direction of an asset’s price. For this you still need other indicators like the DMI.
In addition, I use the expected move on the tastyworks desktop, web browser, and mobile platform.
The expected move is the estimated dollar move of the underlying’s price for a given option’s expiration date in the future with a 68% certainty (ono standard deviation at each side of the strike price).
A one standard deviation range encompasses 68% of the expected outcomes, so a stock’s expected move is the magnitude of that stock’s future price movements with 68% certainty.
The “expected move” represents the amount that a stock is expected to either rise or fall from its current market price based on its current level of implied volatility.
There are three variables that go into the expected move formula:
1) The current stock price
2) The stock’s implied volatility
3) The desired expected move period (expressed as the number of days)
Average Directional Movement Index (ADX/DMI): Strength Trend and Price Direction
The next technical indicator I use are ADX /DMI.
ADX gives great strategy signals when combined with price. Price is the single most important signal on a chart. I read price first, and then I read ADX in the context of what price is doing.
Trading in the direction of a strong trend reduces risk and increases profit potential. The average directional index (ADX) is used to determine when the price is trending strongly. In many cases, it is the ultimate trend indicator.
ADX stands for Average Directional Movement Index, a mathematical derivation used in technical analysis to assess the strength of a price trend in a financial security.
Statistical indicators can help to determine the strength and duration of a trend so that I can anticipate a potential change before it occurs.
The most direct use of ADX is to assess the strength of an observed trend or to validate one that may just be starting.
By their nature, trends cannot be confirmed until they have already begun, so it is a lagging indicator.
Some stocks will have a tendency to trend differently or more frequently than others. ADX comparisons can be used across different stocks to identify those that offer more reliable moves in one direction or the other.
The ADX works together with the positive and negative Directional Movement Indexes (DMI) to measure the strength of price movement.
DMI measures changes in price rather than absolute values of price, and is a type of oscillator that will take the shape of a sine wave moving back and forth from positive (DI+) to negative (DI-) over time.
News or earnings announcements can inspire price moves on stocks, but not all such moves will necessarily expand into a meaningful trend. ADX can help differentiate brief news-related moves from more sustainable trends.
ADX/DMI may work better on some underlyings than others, and better on some trends than others.
Also, ADX/DMI must be seen in the contact of other indicators like Bollinger Bands, Keltner Channel, ATR, RSI, etc.
AVERAGE DIRECTIONAL MOVEMENT INDEX (ADX/DMI)
At what level is the ADX (measuring trend strength)?
0-25: absent or weak trend
25-50: strong trend
50-75: very strong trend
>75: extremely strong trend
How are DMI+ and DMI- signalling price move?
DMI+ above DMI-: price moving up and buy signal
DMI- above DMI+: price moving down and sell signal
Cross-overs signal price move reversion
- ADX calculations are based on a moving average of price range expansion over a given period of time. The default setting is 14 bars, although other time periods can be used.
- ADX is plotted as a single line with values ranging from a low of zero to a high of 100. ADX is non-directional; it registers trend strength whether price is trending up or down.
- The indicator is usually plotted in the same window as the two directional movement indicator (DMI) lines, from which ADX is derived (shown below).
- When the ADX begins declining, the trend may be weakening or ending.
- Low and falling levels of the ADX, particularly below 25, suggest there is no discernible trend at all (see the table below for an overview).
- A trendless market does not necessarily mean the price is declining. It simply means there is little follow-up momentum to prices in either direction at the current time.)
- A high and rising ADX indicates a strengthening trend. A sharp rise of 4 or 5 units in ADX, particularly above 25, could indicate that a new and strong trend is forming.
- Its value, however, relates to the slope of the trend. That means a trend of consistent, but modest, slope may be a worthwhile trend, though characterized by a modest ADX value.
- The Directional Market Indicator (DMI) measures the moving average of the last 14 days of a security’s price changes.
- A positive DMI (DMI+) is the difference between the current day’s high price and the previous day’s high price for the last 14 days.
- A negative DMI (DMI-) is the difference between the current day’s low price and the previous day’s low price for the last 14 days.
- The two DMIs are plotted on the same graph and used to indicate the strength of a trend by virtue of where they line up on a chart relative to each other.
- In general, when DMI+ (or DI+) is above DMI- (or DI-), the price trend is currently moving up, and a buy signal is generally indicated; and when DMI- is above DMI+, the price trend is currently moving down, and a sell signal is indicated. The ADX can then be used to assess the strength of these signals.
- DMIs over a few days may not indicate anything about trends that are weeks or months in duration.
Low ADX is usually a sign of accumulation or distribution.
When ADX is below 25 for more than 30 bars, price enters range conditions, and price patterns are often easier to identify. Price then moves up and down between resistance and support to find selling and buying interest, respectively.
The direction of the ADX line is important for reading trend strength:
- From low ADX conditions, price will eventually break out into a trend.
- When ADX is below 25, price enters a range.
- When ADX rises above 25, price tends to trend.
- When the ADX line is rising, trend strength is increasing, and the price moves in the direction of the trend. It does not mean the trend is reversing.
- When the line is falling, trend strength is decreasing, and the price enters a period of retracement or consolidation. It does not mean the trend is reversing. It means ‘lesss strong’.
- ADX tells you when breakouts are valid by showing when ADX is strong enough for price to trend after the breakout. When ADX rises from below 25 to above 25, price is strong enough to continue in the direction of the breakout.
- Conversely, iADX shows when the trend has weakened and is entering a period of range consolidation. Range conditions exist when ADX drops from above 25 to below 25. In a range, the trend is sideways, and there is general price agreement between the buyers and sellers. ADX will meander sideways under 25 until the balance of supply and demand changes again.
- The best profits come from trading the strongest trends and avoiding range conditions.
When ADX is below 25, the trend is weak. When ADX is above 25 and rising, the trend is strong. When ADX is above 25 and falling, the trend is less strong. Image by Sabrina Jiang © Investopedia 2020
ADX Trend Momentum and Divergence
The series of ADX peaks are also a visual representation of overall trend momentum. ADX clearly indicates when the trend is gaining or losing momentum. Momentum is the velocity of price.
- A series of higher ADX peaks means trend momentum is increasing.
- A series of lower ADX peaks means trend momentum is decreasing.
- Any ADX peak above 25 is considered strong, even if it is a lower peak.
Knowing when trend momentum is increasing gives the trader confidence to let profits run instead of exiting before the trend has ended. However, a series of lower ADX peaks is a warning to watch price and manage risk.
ADX can also show momentum divergence. When price makes a higher high, and ADX makes a lower high, there is negative divergence or non-confirmation. In general, divergence is not a signal for a reversal, but rather a warning that trend momentum is changing.
Any time the trend changes character, it is time to assess and/or manage risk. Divergence can lead to trend continuation, consolidation, correction, or reversal (below).
Relative Strength Index: Price Momentum
A stock’s supply and demand is much like the supply and demand of commodities. Too much supply (oversold) lowers prices; too little supply (overbought) increases prices. RSI is one of the indicators that measure this. The goal is to find imbalances in supply and demand near support or resistance.
The relative strength index (RSI) is a momentum indicator used in technical analysis.
RSI measures the speed and magnitude of an underlying’s recent price changes to evaluate overvalued or undervalued conditions in the price of that security.
The RSI can also indicate underlyings that may be set for a trend reversal or corrective pullback in price. It can signal when to buy and sell.
As a momentum indicator, the relative strength index compares an underlying’s strength on days when prices go up to its strength on days when prices go down. Relating the result of this comparison to price action can give traders an idea of how a security may perform. The RSI, used in conjunction with other technical indicators, can help traders make better-informed trading decisions.
Like all the other indicators, it is a technical indicator that can and must be used with others to support trading strategies.
The RSI is most useful in an oscillating market (a trading range) where the asset price is alternating between bullish and bearish movements.
The relative strength indicator is not as reliable in trending markets as it is in trading ranges. In fact, most traders understand that the signals given by the RSI in strong upward or downward trends often can be false. This is when the Keltner Channel indicator may help me.
RELATIVE STRENTH INDEX
At what level is the RSI (measuring trend strength)?
30-70: not oversold/overbought
- Traders can use RSI to predict the price behavior of an underlying, validate trends and trend reversals, and point to overbought and oversold securities.
- It can provide short-term traders with buy and sell signals.
- The RSI provides technical traders with signals about bullish and bearish price momentum, and it is often plotted beneath the graph of an asset’s price.
- An RSI reading of 70 or above indicates an overbought situation.
- A reading of 30 or below indicates an oversold condition.
- An asset is usually considered overbought when the RSI is above 70 and oversold when it is below 30.
- The RSI line crossing below the overbought line or above the oversold line is often seen by traders as a signal to buy or sell.
- The RSI works best in trading ranges rather than trending markets (see Keltner Channel for those markets).
- The RSI will rise as the number and size of up days increase. It will fall as the number and size of down days increase.
- It can stay in the overbought region for extended periods while the stock is in an uptrend. The indicator may also remain in oversold territory for a long time when the stock is in a downtrend.
The default setting for Relative Strength Index is 14, but you may change this value to decrease or increase sensitivity based on your requirement. For instance, 12-day RSI is more likely to reach overbought or oversold levels than 24-day RSI.
RSI overbought or oversold or trending in a range
Overbought refers to an underlying that trades at a price level above its true (or intrinsic) value. That means that it’s priced above where it should be, according to practitioners of either technical analysis or fundamental analysis. Traders who see indications that an underlying is overbought may expect a price correction or trend reversal. Therefore, they may sell it.
The same idea applies to an underlying that is oversold. It can be seen as trading at a lower price than it should. Traders watching for just such an indication might expect a price correction or trend reversal and buy the underlying.
During trends, the RSI readings may fall into a band or range. During an uptrend, the RSI tends to stay above 30 and should frequently hit 70. During a downtrend, RSI frequently hits 30 or below.
If the RSI can’t reach 70 on a number of consecutive price swings during an uptrend, but then drops below 30, the trend has weakened and could be reversing lower. The opposite is true for a downtrend.
Trend lines (and moving averages) are helpful technical tools to include when using the RSI in this way.
Note: do not confuse RSI and ‘relative strength’ which compares the price performance of two or more underlyings.
RSI Divergence and Reversals
An RSI divergence occurs when price moves in the opposite direction of the RSI. In other words, a chart might display a change in momentum before a corresponding change in price.
- A bullish divergence/momentum: when the RSI displays an oversold reading followed by a higher low that appears with lower lows in the price. A break above oversold territory could be used to trigger a new long position.
- A bearish divergence/momentum: when the RSI creates an overbought reading followed by a lower high that appears with higher highs on the price.
- A positive RSI reversal is when the RSI reaches a low that is lower than its previous low at the same time that a security’s price reaches a low that is higher than its previous low price. Traders would consider this formation a bullish sign and a buy signal.
- Conversely, a negative RSI reversal is when the RSI reaches a high that is higher that its previous high at the same time that a security’s price reaches a lower high. This is a bearish sign and a sell signal.
- A bullish swing rejection is when the RSI falls into oversold territory, then crosses back above 30, forms another dip without crossing back into oversold territory and then breaks its most recent high. The bearish swing rejection is just the pother way round.
Resistance/Support Areas and Linear Regression Trends
In addition to Bollinger Bands and Keltner Channels, finding resistance and support areas and linear regression channels are a great way to identify potential key levels of future price action.
This will help you to see where the majority of price action has taken place, and more importantly help you to pinpoint irregularities that can lead to potentially profitable trading opportunities.
REGRESSION TRENDS and RESISTANCE/SUPPORT AREAS
Are there clear Resistance and Support Areas (R/S)?
Are the R/S Areas outside the ATR and Expected Move ranges?
Is the Linear Regression Channel confirming the trend?
Is the coorelation (RPIerce factor) high?
Resistance and Support Areas
What Is the Zone of Resistance?
The zone of resistance is the upper range of a stock’s price that shows price resistance, with the lower range being its support levels. Understanding a share price’s zones allows investors to buy and sell shares in order to maximize their short-term gains. It may therefore be contrasted with the zone of support.
The zone of resistance is an important concept in technical analysis. Technical analysts look for signs that a stock price is moving through the zone of resistance and establishing new support and resistance levels.
- A zone of resistance is the price range achieved when a security’s price rises to a predicted near-term high, known as a support level.
- A zone of resistance is an upper boundary that the stock has not previously broken through, and is the opposite range to the zone of support.
- A zone of resistance provides high probability areas where a reversal or continuation of an upward trend may occur.
Breaking Down Zones of Resistance
Most day traders buy and sell on the belief that support and resistance zones maintain themselves for extended periods of time. This logic follows the rules of basic supply and demand. As more shares are purchased at the lower support level the price begins trending upwards until it meets the zone of resistance and selling sends the price back down.
As is the case with all technical analysis, there are key times when the zone of resistance and support levels of a stock will be reconfigured by external events, which is why experienced technical traders rely on several charts when attempting to predict future price moves. A move through the zone of resistance may be confirmed on a chart as a new breakout opportunity for taking a long position in a stock previously traded solely within the support and resistance levels.
Oftentimes this breakout occurs due to fundamental changes in the company’s performance, such as a new product launch or news about market share gains and improved cash on hand.
Using Trend Lines to Mark Zones
Support and resistance zones are utilized by technical analysts to study past prices and predict future market moves. These zones can be drawn using simple technical analysis tools, like horizontal lines or up/down trendlines, or by applying more advanced indicators, such as Fibonacci retracements. Market psychology plays a major role in a given instrument’s price movement as traders and investors remember the past, react to changing conditions, and anticipate future market movement.
Trend lines are useful in painting a more complete picture of stock movement over time. Within every significant price move up or down there will be times when plateaus are reached and the stock price drifts sideways. An example of a plateau occurring within an overall price move upwards is seen in a bull market when investors look to lock in gains across many stocks. The risk here is they will miss a significant ongoing move upwards thinking the plateau is the beginning of yet another downward move, when in fact it is just a rest on the way to new highs.
Using trend lines can help investors see the longer-term trends in a chart so they don’t set their strategy solely based on short-term movements.
The Zone of Resistance and Other Technical Indicators
Technical investors rely on several indicators to help them make informed decisions. In addition to the zone of resistance, traders monitor moving averages (MAs), candlestick analysis, and daily stock volume to help predict the next moves up or down.
Traders look for confirmation in a chart to identify when a breakout is underway in terms of setting new resistance and support levels. Volume is an excellent indicator of interest in a stock and as volume increases, so does the likelihood that a new high or low will be established.
Regression Trends in General
When using regression trend tools in charting platforms like TradingView or Barchart I either choose two points on a trend, generally at the beginning of the trend and the end of the trend, and/or select a specific period (I use 1, 2 or 3 months).
Understanding Regression Trends
- When the two points on the chart are chosen, the normal distribution of the dataset is calculated between the two chosen points and displayed in the form of a linear regression channel.
- The center line in this channel is the linear regression line or (‘mean’), and the upper and lower lines are the two standard deviations (68% each) from the mean as set in the tool’s settings (default settings are +2 and -2 standard deviations from the mean; you can change this to +1/-1 or +3/-3 standard deviations).
- The correlation of this linear relationship is displayed as Pearson’s correlation coefficient , or Pearson’s R.
- Pearson’s R shows the strength of the correlation as well as its direction, with values moving between -1 and 1.
- As Pearson’s R moves further away from zero, the strength of the linear relationship between price and time increases.
- Pearson’s R will always be set as an absolute value (positive), but the direction of the trend can be visually identified.
- When a regression trend has a high correlation, this is due to the consistency of price action laying along the mean (center line), with fewer points moving above and below the mean line to the upper and lower standard deviation levels.
- A channel containing more bars and having a high correlation is more likely to have price continue in that trend than one that is graphed with only a few bars and having a high correlation.
- The length of the trend should be considered when trading these channels.
Trading with the Linear Regression Channel
One way to trade using a linear regression channel is to trade the price action as it moves away from, and back to the mean.
It can be used for many trading strategies from swing trading, breakout trading, momentum trading, as an overbought and oversold indicator and many more.
You can also set the linear regression channel to two standard deviations from the mean which is 95% of the data points, or three standard deviations which is 99.7% percent of all the data points.
This linear regression indicator is using a 2 standard deviation input from the mean. We selected the first anchor point at the bottom of the chart which represented a major swing low. Then we stretched that upwards to the second anchor point, which is a major swing high on the price chart. Upon selecting these two levels, the linear regression channel was automatically plotted on the chart.
The central line represents the mean, while the upper and lower lines represent 2 standard deviations from the mean. These upper and lower boundary lines take the form of parallel lines displaced from the mean based on the specific standard deviation set, which in this case is 2.
Essentially this linear regression channel allows us to see where 95% of the price action has occurred. I like to use 2 standard deviations as a default setting.
I mainly use the linear regression channel to find ‘confluence’ near a support or resistance level as evidence that there are more indicators pointing in favor of my intended position.
I first try to find a key horizontal support or resistance area on the chart. And then I plot a linear regression channel as price nears that key level.
The linear regression channel coupled with the key horizontal price level, will provide a price and time projection for a potential reversal play. Typically, on this type of setup, you would want to buy at the close of the candle that reacts off the intersection of these levels.
I only select underlyings that have no scheduled earnings or dividend events in the next 30 days and about which there is no material news.
Also, watch out for divided record dates. If either an option seller’s short call or option buyer’s long put is exercised just prior to a dividend record date, the dividend value must also be delivered with the optioned stock.
At what level is the RSI (measuring trend strength)?
30-70: not oversold/overbought