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Lesson 11: The choice of the Options – First Part

The Choice of the Options, Stock Options, Options Course

The Choice of the Options, Stok Options, Options CourseUntil now we have seen a lot of theory, let's see now a bit of practice and how to choose underlying and options to build our Vertical Spread.

First, we have to choose the underlying that may be a stock, an ETF, a future. It is fundamental to analyse it graphically. How to do? Using some indicators that allow us to determine if the underlying is on trend or not. These indicators are the Relative Strength Index (RSI) and the Bollinger Bands.

The Relative Strength Index is one of the most famous and used indicators in trading. Conceived by John Wilder in 1978 and detailed in his book New Concepts in Technical Trading Systems, it serves to highlight areas of oversold and overbought on the market and can be applied to all charts, even in a spread.

With the RSI, so, we identify excesses of sales and purchases. The indicator consists of a scale from 0 to 100, below 30 we will have an area of oversold and over 70 we will have an area of overbought.

You can see an example in the chart of Apple below.

Apple chart, Options, Stock Options

 

Also important to the level of 50 that acts as a watershed between the uptrend and downtrend because under 50 take precedence the sales and over 50 will prevail the purchases. Usually is used the 14-period RSI, but this does not prevent you from changing it in according to your needs and type of analysis. For example, I use the 7-period RSI as well.

Therefore, this indicator is based on the assumption that after a prolonged downtrend or uptrend in prices, it becomes much more likely a slowdown of the movement aimed to run out the excess of sales (oversold) or purchase (overbought).

Another interesting aspect is the divergences. What is a divergence? A divergence occurs when the RSI moves in a way opposite to the movement of the price. We have a bullish divergence when we have lower lows on the price and higher lows on the RSI as shown below.

 

Bullish Divergence, Options, Stock Options

 

We have a bearish divergence when we have higher highs on the price and lower highs on the RSI as shown below.

Bearish Divergence, Options, Stock Options

 

When on the chart will form a bullish divergence, there will be good probabilities that the market will rise. At the same, when there will be on the chart a bearish divergence we have better probabilities to see the market falls soon.

You can see an example in the chart of IBM below.

IBM chart, Options, Stock Options

 

Bollinger Bands get their name from its inventor, John Bollinger, and are very useful to identify stages of expansion and contraction in volatility.

Bollinger Bands are three lines. The middle one is a moving average, usually at 20-period, the upper band is obtained by adding two standard deviations of the moving average, the lower one by subtracting two standard deviations of the moving average.

Applied to a chart, we will see the price move inside of the two bands (upper and lower) for about the 95% of the time. You can see an example in the chart of Apple.

 

Apple chart, Options, Stock Options

 

Often after a shorter or longer period of low volatility with the two bands that have moved very close together, you can see an increase in volatility with the bands that perform the opposite movement with an increase in the distance.

Passing so from a closer to a broader movement, up or down, because very narrow bands often coincide with phases of market accumulation or distribution.

 

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