A fool’s guide to directional trading

First off, as is evidenced in the title above, this post is all about directional trading on any desired market. As I always try to do, I’ll also supply an example along the way to solidify my ramblings.

Please be aware that this approach represents just one of thousands or maybe millions of different methods to analyze market direction. So, the information that follows is strictly my own personal opinion. In any case, the following will be a rather detailed discussion on directional trading, you know, from one fool to another.

So, thinking logically about a directional trade I must first know the path I’m taking to a great trade. Essentially, I must know the set of steps in the plan before actually performing those steps. Why?

Because not having a predetermined plan opens the door for “winging it” and I know we’ve all been victim to that nasty habit.

Here’s an example;

1. Identify monthly, weekly, daily, hourly trend lines.
   1. Do they all agree? Disagree? Some combination of Both? Which?
2. Overbought or Oversold?
3. Support or Resistance?

*Each of the 3 steps are determined separately but used collectively. This will be explained below.

And that’s it! Don’t get carried away with 20 different indicators. Especially when first starting to trade! Trust that the chart itself will tell you absolutely everything those 20 indicators wish they could. The difference between those that use the 20 indicator approach and the method I’m preaching here is nothing more than two different belief structures. They, just like me, are only trying to uncover the story price is telling them. That said, muting price in favor of several indicators can steal analytical focus and I don’t see that being the most effective use of time.

However, if you must use several indicators please check out the most used technical indicators page to enhance your own directional trading. For this particular analysis I’ll be using two indicators, to determine overbought or oversold levels. If your interested to read more about these two indicators please view the RSI indicator page here or visit the Bollinger %B page here.

Lets walk through each step with an example on Nike (NKE).

Step 1: Identifying trend lines for directional trading.

Monthly

Click each image to enlarge.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Now, we’ve conducted a thorough trend line inspection and upon review, we can see a few things.

1. Strong bullish long term up trend.
2. Bearish to neutral intermediate trend.
3. Bullish short term trend.

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**Always remember this about options trading. Most chartists are interested in just one thing. Direction. We’re interested in both time and direction. Every time. (Mostly because we’re better in every way but that will be discussed later :P)

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How should we play this and what is our time horizon? Anything under 30 days is short term, between 30-75 is intermediate, and anything above 75 days is long term. I often prefer trading the intermediate range over short or long term. Simply because liquidity in the options market increases nearer expiration and the assignment risk compared to very near expiration options is lower.

Answer: a short or long term position is ideal, at this time.

*I won’t dive into it here but determining whether to have a bullish or bearish bias would depend ALOT on the pricing and volatility of the available options in my chosen time frame.

Step 1 Decisions

• Short or long term trade (under 30 days or more than 75)
• Bullish bias.

 

Step 2: Is Nike currently over bought or oversold (OB or OS)?

From the chart it’s pretty clear Nike is in overbought territory. This means, Nike can expect to experience a trend reversal or, at minimum, a retracement before continuing the trend.

 

Step 2 Decision

• Nike will retrace or reverse.
• Bearish bias.

From the image above, please also note the price level I’ve drawn in. This is a level of resistance and COULD force prices lower.

 

Step 3 Decision

• Nike trading at Resistance
• Bearish bias.

 

Lets bring it all together and add up our 3 steps.

• Short or long term trade?
• Bullish (trend lines)
• Bearish (OB/OS)
• Bearish (Support/Resistance)

The answer to direction decision rests with our answer to time horizon. Do we want to capture a lower percentage of profit quickly or do we want to aim for a higher percentage of profit over a longer period of time.

Human nature demands we trade short term and collect money now, but logic requests our patience to earn a larger reward. What’s kind of funny is that either choice can be acceptable.

To close this post I’ll include a picture below of both short and a long term positions. Highlighting that either side can be profitable, so long as time horizon has been dually considered.

Here are some words of wisdom before you go:

There is a common quote floating around that traders are supposed to cut losses short and let winners run. We’ve all heard it, the problem with that statement is: IT WAS NEVER INTENDED FOR OPTIONS TRADERS! Letting your winners run can and will turn those winners into losers.

Short Term Trades (<30)

Bullish

 

 

 

 

 

 

Bearish

 

 

 

 

 

 

 

Long term Trades (>75)

Bullish

 

 

 

 

 

 

 

Bearish

 

 

 

 

 

 

 

As is shown, all but one trade was profitable at some point prior to expiration. Highlighting the fact that directional trading is best when equally applied to a portfolio of other directional trades.

Happy Trading,

Jeff “the OptionBoxer”