Understanding technical analysis is an art form that is shaped by experience – and it is critical for trading options. As a charting veteran, I have evaluated thousands of charts, a daily ritual that typically includes 100 charts in a single day. That may seem exhausting, but it is required if I want to perfect my craft and find the next winning trade. Nobody will hand me a trade idea; I have to work for it.
I first learned about technical analysis at San Diego State in 1990 during a class called “Portfolio Management.” I had a brilliant instructor who talked about different tools and models and dedicated two of our twenty five sessions to technical analysis. He prefaced his introduction to the subject by saying it was useless and it was certainly going to fade away. As a contrarian, that’s all I needed to hear, and I decided then and there to learn more about this thing called technical analysis.
Let’s switch topics really quickly, because what I encountered in the late 1990s will perfectly illustrate why technical analysis is so important when trading options. Early in my career, I made it a practice to analyze financials, but I kept beating my head against the wall trying to understand valuations. It made little sense to me that a company could have such a rich valuation that was wholly undeserved.
Perfect example: Back in the late 1990’s, Brocade Communications was selling at 100x sales at its peak price. From a fundamental perspective, that was just absurd! Forget about the price/earnings ratio, which was ridiculously lopsided. It would take 100 years for this company to grow into this valuation. Contrast that with Apple today, which currently sells at just under 4x sales.
What startled me at the time was that this stock kept going up and up towards that out-of-sight valuation. Before Brocade and other stocks started their meteoric rise, they were already overvalued on a fundamental basis! There was nothing stopping this stock (or others) as it moved to higher ground. Sure it was ridiculous, but that didn’t matter (eventually it would, as we all know). I found that trading/investing from the dark side was not so bad! The charts and technicals defined the price action, and if more buyers piled in, that made the charts look better. Sometimes a price objective became a self-fulfilling prophecy.
Charts and technicals give us a good read on investor/trader sentiment. We need to understand where the money is flowing, why it’s moving, and how to capitalize on it. While the fundamentals may help explain the long-term trajectory of a company, analyzing a chart is the best way to time an entry or exit. Follow the big money – it is our best guide.
