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Market Trend Analysis for Options Trading

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Almost all options traders have heard the age old trading adage that says “The Trend Is Your Friend”. Indeed, trading options in the direction of the prevailing market trend definitely puts the odds of winning in your favor. Too many beginners to options trading has lost entire accounts by buying call options in a bear trend market and buying put options in a bull trend market.

So, what exactly is a market trend?

Market trends are like ocean tides. You know it is a rising tide when you see the sea coming higher and higher up a beach and you know it is a lowering tide when you see more and more of the beach. Similarly, you know it is a bullish trend when you see the major indices such as the Dow Jones Industrial Average or the S&P500 going higher and higher and you know it is a bearish trend when you see the major indices going lower and lower.

Yes, market trends are general directions in which stocks seems to be moving. In a bull trend, the prices of most stocks will be moving higher and higher and in a bear trend, the price of most stocks will be moving lower and lower.

However, one thing to understand about trends is that trends are a “General Direction of Movement”. It does not mean that in a bull trend, the market only move upwards every single day and it does not mean that in a bear trend, the market only move downwards.

If you observe ocean tides, in a rising tide, the sea doesn’t keep rushing onto the beach but comes in “Waves”. One wave higher than the previous one. This is the same thing in stock market trends. In a bull trend, you will see up days interspersed with down days. However, up days will happen more frequently and will make new highs following each slight retreat.

This fact frequently comes as a surprise to new traders who interpret the first down day in a bull trend as the market “turning bearish”. This is also how beginners and veteran options traders alike fall for the proverbial “Bull Trap” and “Bear Trap”, which are short counter-trend moves that are misinterpreted as trend changes. Traders who fall for either trap usually find themselves surprised when the general trend resumes and they are caught in a losing position that never gets turned around.

Recognizing how trends really work is only the first step to recognizing market trends. Have you ever arrived at the conclusion that the market is in one direction only to have a peer disagree with it? How can two person looking at the same market come to different conclusions about what the market trend is?

The complexity of recognizing market trends come with the realization that the market can really be in all three directions on the same day at any one time!

The market might be in a bear trend for daytraders but on the same day, it may be in a bull trend for a swing trader and a neutral trend for a long term investor. How is that possible?

Actually, there are not just one “Market” condition but countless market conditions depending on the time frame one is trading on! It is the failure to recognize that market trend is different for different trading horizons and investment objectives that led to all the futile argument over what trend the market is in on TV.

If you have a charting software, you might be shocked to see that frequently, you will see a completely different chart pattern on the same index or stock depending on what time frame you are looking at; 1 min chart, daily chart, weekly chart or monthly chart, each of them seems to tell you a different thing.

A chart that looks extremely bearish on the 1 min chart might look extremely healthy and bullish on a daily chart. As such, the analysis of trend requires first and foremost an understanding of the exact time frame that you are trading on.

Recognizing the exact time frame you are trading on is an extremely important pre-requisite in options trading where the options contracts and positions you bought are time sensitive! Yes, options positions don’t last forever and all options strategies have an ideal time frame within which to make an optimized return.

For instance, if you are day trading with options and either writing or buying options in order to close them out for a profit by the end of the trading day, the market trend you should be concerned with would be the intraday trend identified most commonly with the minute charts. In this case, whether the market is in a long term bull or bear trend doesn’t really affect your trading anymore. The world might be shouting bullish but if your minute charts are showing bearish for the day, then bearish is the direction you make your money from.

If you are trading a Covered Call, you might want to write the call options on a stock that is relatively sideways on the daily charts with the market trading within a range on the daily charts if you intend to keep the stocks from being assigned.

Conversely, if you are buying long term LEAPS options, you might be more concerned with what the longer term trend of the market is instead of being too concerned with the day to day volatility.

So, what are the most common tools to use for market trend recognition?

Most veterans are capable of recognizing the trend a chart is in simply by looking at how the price chart looks like. However, for the less experienced or more technically inclined, countless complex technical indicators have been invented over the ages. Personally, the most time proven one is the Simple Moving Average. Which is simply averaging the price over a period of time to see where it is generally moving towards. This is what I personally rely on most of the time and I use a different period moving average for different time horizons. Most commonly used are the 30days or 50days period.

 

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