CHAPTER 4

Chart-Based Analysis

An options trading program can be based on the combined use of fundamental analysis of companies and technical analysis of stock prices. These two approaches to investing and trading complement one another by providing a broader perspective on value and risk.

Trading options based on the timing of entry or exit can be accomplished effectively, not to attempt to profit 100 percent of the time, but to improve occurrences of profitable timing above the average.

Criteria for Chart-Based Analysis

Four key criteria should be applied to chart analysis. These are:

1. Limit yourself to fundamentally sound companies

   The starting point for every conservative portfolio is the disciplined selection of its components. Managers set criteria for investments to include in the portfolio, and ultimately the success of investment activity depends on how well you can stay with those criteria and avoid the temptation to take risks beyond your carefully defined limits.

2. Seek adequate reversal and confirmation

   It is not enough to simply spot a reversal signal. No portfolio decisions should be based on single indicators. You need to ensure that a signal is confirmed independently before acting; and two or more forms of confirmation are desirable. Finding reversal and confirmation in the underlying security leads to a determination of which options to trade based on those signals. A related and equally important guideline is not to act if you don’t find those signals; the purpose of finding reversal and confirmation is to improve your chances of well-timed entry and exit.

3. Seek many different forms of confirmation

   If you use many different indicators in combination to find points for entry and exit, you improve the likelihood of profits. Traders tend to identify a very short list of favorite indicators and look only for those, without being able to expand the search horizon. This is a mistake. The more indicators you locate to spot reversals and confirm them, the better your overall outcome is likely to be, and the higher the experience of profits over losses.

4. Diversify in terms of dollar amounts traded

You might be able to create a nicely diversified portfolio of equity positions but overlook the importance of limiting risks through the dollar amount traded. For example, if you set a limit of $1,000 per trade on long positions, you never place more than $1,000 at risk. The mistake traders make is to set the rule and then violate it. They see what looks like a great opportunity and put in $7,000; it turns out to be one of those poorly timed traded that everyone has from time to time. As a form of diversification, keeping the trading levels the same for each trade makes sense and is really the only way to manage the market risk of buying and selling options—even with conservative strategies.

Finding Fundamentally Sound Companies

Criteria for picking stocks can be applied as a starting point. Chapter 13 examines in detail a sample of five criteria: revenue and earnings, capitalization and working capital, PE ratio, core earnings, and dividend yield.

All of these criteria should be studied as trends. Analyzing the 10-year history of these criteria reveals the strength or weakness of the company on a fundamental basis; no one-year status or results can tell the whole story. When the fundamentals are added to technical analysis, you build a strong portfolio of value investments that also offer strong growth potential.

Using Many Different Reversal Indicators in Combination

The key to chart analysis is to use many indicators in combination. Relying on any single indicator is dangerous because an indicator, by itself, is not adequate to generate entry or exit.

You need at least two separate indicators revealing the same likely next change in price; preferably, having even more is better. A collection of many indicators is always stronger than any one signal by itself.

There are points in the trading range at which many indicators have more significance than other points. When the price is near resistance or support, reversal becomes more likely than at any other point in the trading range. When price moves above resistance or below support, reversal is even more likely to occur. This is true when the breakout occurs with strong reversal signals, including price gaps, candlesticks, or double tops and bottoms.

Diversification in Terms of Dollar Amounts Traded

Conservative portfolio management involves two attributes that might seem to contradict one another at first glance. First is the desirable selection of strong value companies as portfolio components on a buy-and-hold basis or at least for more than just a speculative in-and-out move. Second is the idea that on a technical basis, you might move in and out of positions when price trends turn or when the fundamentals change.

Fundamentals change occurs and should not be ignored. For example, a profitable company loses market share or peaks out and begins losing profits, a troubling change. Or a once equity-based company loses profits and begins capitalizing its operations using long-term debt, another dangerous change in the fundamentals. When the profitability and capitalization picture began to change, the smart move is to sell and look for stronger alternatives.

A Study of Charts for the Model Portfolio

The three stocks in the model portfolio qualify on a fundamental basis, based on a review of revenue and earnings, PE range, dividend yield, and capitalization (as measured by the debt to total capitalization ratio). However, on a technical basis, all these stocks go through periods of bullish and bearish trends. Using options, you can have the best of both worlds: keeping a portfolio of value investments for the long term and applying conservative options strategies to time trades based on movement and reversal of trends.

To show how this works, the following section is a summary of the three companies and an analysis of their three-month stock charts as of April 25, 2019. Included in the indicators besides price are:

• Bollinger Bands, a volatility indicator of three bands, a middle line representing a 20-period moving average; and an upper and lower band representing two standard deviations from the middle line.1 The distinction “20, 2” reveals that the chart’s Bollinger Bands represent 20 periods and 2 standard deviations. When price moves higher than the upper band or lower than the lower band, it signals that the price level has moved out of range, and a correcting change is likely.
• Volume, which is useful for spotting likely reversal timing. When you see a volume spike, it identifies a likely moment when the current trend is about to be exhausted and a reversal is likely to follow.
• Relative Strength Index (RSI), a momentum oscillator that identifies when a stock is overbought or oversold. RSI is based on an index between 0 and 100. When the calculated RSI value trends above 70, the stock is overbought and is likely to decline; and when it moves below 30, the stock is oversold.

In addition to these features built into all the charts, the following identifies price movement in the form of traditional technical signals, candlesticks, and movement near or at resistance and support. No one signals can predict consistently when to enter or exit a position, but in combination, these indicators confirm one another.

The charts are busy with a lot of detail. However, by tracking each highlighted indicator, you will get a good idea of how the charting process works and how reversals are spotted.

AT&T (T)

The three-month chart of T reveals numerous important technical signals. These signals are shown in Figure 4.1.

Figure 4.1 AT&T, three-month chart

Source: Chart coutesy of StockCharts.com

The following noteworthy signals are seen on the chart:

1. Four candlestick reversal signals. Marked on the chart are bearish meeting lines, confirmed a week later by a bearish engulfing; and a bullish harami confirmed immediately by a three identical white soldiers signal. The combination of reversal and confirmation adds strength to indicated reversals.
2. Prices outside the outer bands. It is unusual for prices to violate the two standard deviations represented by the outer Bollinger Bands. When this occurs, an immediate retracement back into range should be expected. In this case, the bullish trend continues but the two band violations are connected within a single day. At the end of the chart, recurring gaps took price to close below the lower band. Price retraced higher on the following day (data not shown).
3. Gaps. Piece gaps are common, but large price gaps are rare, notably as they recur in a short time span. These cases involved two consecutive gaps, the first one covering nearly two full points.
4. Volume spikes. Among the strongest reversals is the volume spike, but it matters where the spike is seen. On this chart, two significant spikes are identified. The first occurs at the bottom of a downtrend, anticipating the strong upward reversal two weeks later. The second occurred at the end of the chart, where recurring gaps moved price below the lower band.

Southern Co. (SO)

This company’s stock price has not been as volatile as some, and in fact showed a bullish trend for the first two months. Significant price signals were accompanied by momentum; however, these were good examples of false signals, as shown in Figure 4.2.

Figure 4.2 Southern Co., three-month chart

Source: Chart coutesy of StockCharts.com

1. Resistance and support tracking. Bollinger Bands provides exceptional dynamic tracking of resistance and support during long-term trends. On this chart, the upper band tracked rising resistance, and the middle band tracked rising support.
2. Price above upper band. Two separate moves of price above the upper band appeared as bullish breakout at first glance, but both were false signals. Price retreated into range immediately.
3. Overbought signals in RSI. Although RSI is normally a reliable momentum oscillator, in this case the two instances of overbought confirmed the price moves but were false signals. In each case, momentum levels returned to mid-levels, and price continued rising.

Altria (MO)

This is a chart with low activity and a lack of strong signals, as shown in Figure 4.3.

Figure 4.3 MO, three-month chart

Source: Chart coutesy of StockCharts.com

1. Upper band tracking rising resistance. While volatility was high, considerable space was seen between middle and outer bands. As volatility declined, the upper band tracked rising resistance closely.
2. Momentum anticipated an end to the trend. RSI moved into overbought and remained there for an unusually long time, about two weeks. As RSI retreated into midrange, it marked the end of the bullish trend.
3. Large downward gap anticipated a bullish reversal. Big gaps are exceptions, especially when they move price outside of the Bollinger Band range. At the end of the chart, the large gap anticipated a bullish reversal, which occurred next (data not shown).

For conservative traders, the analysis of chart patterns improves the timing for all entry and exit from trades. However, even with this worthwhile information, you need to continuously manage profits and losses and keep a conservative theme in your portfolio. The next chapter explains how this is accomplished.

Class questions for discussion and/or mini-case studies

Multiple choice

1. Fundamentally sound companies are defined in part as those with:

   a. Significant net profits in the most recent fiscal year.

   b. Growing revenue and earnings over the past 10 years.

   c. Higher than average dividends without regard to other signals.

   d. Decreasing revenues but increasing net profits.

2. A reversal should be acted upon when:

   a. Chart signals are strong, and confirmation is also strong.

   b. Only one reversal is located, whether confirmation is also found or not.

   c. Fundamentals are strong at the same time.

   d. The reversal is found only in the price trend.

3. Diversifying in trades may consist of:

   a. Spreading investment dollars among all stocks in the same industry.

   b. Picking the lowest-priced stocks only to get more variety.

   c. Equal numbers of calls and puts on the same stock.

   d. Using about the same dollar value for each trade and using several stocks.

Discussion:

Get updated charts for the three stocks in the mode, portfolio (T, SO, and MO) and identify key reversal and confirmation signals for each, as well as other important and noteworthy elements found on each chart.

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