Welcome to the BlackBoxStocks blog two-part examination of technical analysis 101. Technical analysis is a wide-reaching endeavor, and there are hundreds of successful technical approaches to day trading options and common shares of stock. But none of them will be successful when applied out of context or without an understanding of the indicators and strategy applied. This second part will focus on technical chart pattern trading as taught by some of our moderators and how to use option delta to conduct a proper risk-reward analysis for option trade entries and exits.
There are many famous chart patterns, but all of them must be traded properly. Today we focus on four of the most famous: the Double Top, the Double Bottom, the Bull Flag, and the Bear Flag. Properly identifying chart patterns and knowing what they likely signal is part of the equation. But technical traders must also know when to act on a pattern and when to sit out. Just seeing a pattern forming on a chart is not enough. In fact, while a pattern is forming can lead to excitement and all too often an early, and botched, entry. Chart patterns need confirmation on several levels. Today we cover four of the most famous in the world.
DOUBLE TOP CHART PATTERN
Let’s begin with the famous bearish reversal signal pattern, the double top. This pattern features two peaks in short succession. See the image below:
The double top pattern looks similar to an upper-case M in the chart. It often signals a bearish reversal when confirmed, and too many traders attempt to trade this pattern before confirmation. So what counts as solid double top confirmation and where should entries and stops be?
In the image above, you see three areas marked: the first peak, the second peak, and the reversal area between them. This in-between area, marked with an arrow, can be called the “trigger.” This trigger is a key to the pattern. As taught at BlackBoxStocks, this pattern is not actionable unless price action falls past this trigger level. Additionally, the most conservative approach is to only play it if it breaches the trigger level with convincing relative volume. In the image above, there isn’t convincing relative volume but the price action does meander around and continue down after rising above the trigger for two candles. If this had been a convincing onrush of volume, price action would have likely continued down without the first stairstep displayed in this image.
Where to put your stops?
Never enter a trade without knowing where you will stop out before you place the trade. Often, traders will play the bearish reversal double top with a stop loss placed at the pinnacle of the second top. Depending on how far down the trigger was, this can become problematic if the trade begins snaking sideways in-between the trigger and the second top. Always honor your time horizon and pre-arranged stop when trading any pattern.
DOUBLE BOTTOM CHART PATTERN
The double bottom, as one may surmise, is the inverse of the double top. All the above applies in inverse, but in the spirit of discussion let’s look at the image below.
In this classic bullish reversal pattern, you see a W-shaped formation in the chart consisting of the bearish action into the first bottom, the in-between peak, the second bottom, and the rising price action, now turned bullish.
The same paradigm exists, with all the above caveats applying. Do not front run the double bottom (or any pattern!) without volume-laden confirmation. To play this pattern, the entry can be the candle at 10:21 am which rises above the trigger peak with volume. Even though it’s not visible on this image, this double bottom (unlike the afore-discussed double top example) did in fact have convincing volume, especially on the 10:24 convincingly bullish candle. An entry here with a stop loss at the bottom of the second bottom with a properly sized position for your unique risk tolerance and account size would have been an informed entry. It should be noted that for both the double top and double bottom that a more conservative stop loss placement can be just below the trigger peak. Sometimes there can be a good amount of distance between the double bottoms and the trigger, so if this is the case that could be a better option for many traders.
BULL FLAG CHART PATTERN
The Bull Flag (also called the bullish flag) is a very famous, and often confusing, pattern in the world of technical trading. A bull flag will develop during strong up trending markets and there are several physical patterns that can fit into this description. The nomenclature derives from the fact that the pattern resembles a flag atop a flagpole. There will always be an uptrend rise, often sudden, that is followed by a consolidation period of various lengths. Regardless of how one interprets the pattern, the uptrend will physically resemble the “flagpole,” and the consolidating group of candles will comprise the “flag.” The “flag” might be straight out from the pole, but it is often oriented at an angle away from the present bull trend.
Some traders get too hyper-focused on the shape of the flag. What is important is that a clear bullish upward momentum trend has entered a period of consolidation, often with lower relative volume than the “flagpole” experienced. When price action breaks above the consolidating flag with volume, it often results in a very strong move upward.
There is a variation when the flag forms a symmetrical triangle, and this is often referred to as a bull pennant. However, the mechanics and theory behind it are very much similar.
Flag patterns are generally very reliable, and they always appear in trending markets. They can be observed on various timeframes, and as they are so famous they have the benefit of many traders and algorithmic programs being aware of and looking for, them throughout every trading session.
The image above is an example of a muted bull flag. The two green candles form the “flag pole,” and the following alternating color consolidation candles form the flag. Notice that the flag bars have much lower relative volume than the flagpole and that volume comes in convincingly to begin the next move up. There are more pronounced versions of bull flags all around the internet, but this is a great example of a more muted one. Hopefully examining it can drive home the point of how important volume is.
BEAR FLAG CHART PATTERN
As the double bottom is to the double top, so is the bull flag to the bear flag. The bear flag (and also the bear pennant) consists of an inverse set of factors and reasoning to the bull flag. The idea is the same, a strong directional move (downward in this case) is followed by a brief period of drifting consolidation. See the image below.
In this image, it is clear that starting at 13:25 downward pressure began. Three candles down resulted in four consolidation candles. Again, notice that the consolidation candles are drifting counter directionally to the trend. When price action continues downward, larger relative volume is observed on the 13:32 candle. When price action continued down past the top of the flagpole, this would have been a data-informed, and profitable, entry for a short-term scalp of five or six candles. Exits are personal and always up to the individual, but I would have been scared into taking profit and closing the entire position by the big green relative volume candle at 13:38.
RISK REWARD ANALYSIS
One of the most paramount skills any trader needs to the ability to accurately and confidently chart support and resistance on charts. Trading a chart without support and resistance already carefully plotted is uninformed and potentially disastrous. Volume and a trusty chart pattern may look great; however, if price action is approaching a strong area of support or resistance, a trader can be surprised by the unexpected reversal. When planning an options trade, the first step is always plotting support and resistance. Hopefully, you also know the ticker and its recent history as well as any forthcoming market events, such as earnings for example.
At this point, the game involves establishing an entry and a stop loss. However, after that how can you know when you will be likely to close out the trade if it goes your way? Of course, you can always close a trade when you are happy with the gains. But advanced traders will close only based on support or resistance. For instance, if price action is strongly headed upward on SPY, but there is an area of long-standing heavy resistance on the chart at approximately one dollar above the current price, how can we calculate if this is a good entry or not?
The beginning is having knowledge of the ticker. In the case of SPY, is a one-dollar move typically made in a short time frame or not? What time of the day is it? What has the price action been like over the course of this day? And then, there is our old friend Delta.
All options traders need to be aware of the Greeks and how to use them. Delta is very useful in estimating risk-reward. Remember that delta is the amount in price the option contract will move per a one-dollar move in the underlying stock. A .5 delta means the options contract will move .50 dollars for every one dollar SPY moves. Since an option contracts control one hundred shares, this displays the inherent leverage in options. If you buy one contract of a SPY call that is at-the-money with a delta of .5 when SPY is trading at $426, then the option contract will increase in value fifty dollars if SPY goes to $427. If delta was .35, then the option contract would move 35 cents for every dollar SPY goes up or down. The higher the delta, the more the contract will move upward (and downward) with price action.
Thus it is easy to see if you think that gain would be worth the risk of buying a .5 delta SPY call in an uptrend with underlying at $426 with major resistance looming overhead at $427. An uninformed trader ignorant of said resistance at $427 could likely see the quick rise of fifty dollars in their contract and hang on hoping for more just to be disappointed when it reverses on them. However, a savvy trader well aware of the $427 resistance will likely happily sell as price approaches the area and be pleased with a 46 or 47 dollar gain per contract. And if that isn’t enough reward to risk the position, the informed trader would simply wait and perhaps play puts off the $427 rejection. Regardless, being able to take profit from a data-driven stance is extremely important for short term time horizon day traders. Of the many truisms in the stock market, none is more true than Greed Kills. A good option trade entry will know where the stop loss and the take profit area is before entering the trade.
Regardless, spend the time to learn your Greeks. Support, Resistance, and Delta are your good, good friends.
Be aware that the four patterns mentioned earlier today are four of the most famous; however, they are not by any means the only useful patterns to be able to trade. Remember, all patterns must have confirmation via a trigger level breached with volume. To return to the much written about and oft traded bull flag pattern, price action forms the flag in the sky but volume is the wind to make it unfurl and live up to its true potential.
Trading technical chart patterns with a solid basic knowledge of one’s chosen patterns and the greeks can help reduce risk to the active day trader. Be well traders, and stay green!