Before we talk about how to use chart analysis, I have a little options trading riddle for you: A good trade could be the right trade, though the right trade may not be a good trade.
Huh? Yeah, I bet you’re scratching your head by now.
As options traders, we are constantly looking for the best probability play, so let’s dig in to see if we can figure out the difference.
Is it a good trade, or the right trade?
The key to solving the riddle is applying chart analysis. This allows you to take the trade to a deeper level. By narrowing down the odds, it will increase your trade probability.
Some traders argue that the technicals don’t provide the “right” answers, because they only give you a glimpse back into the past. But as a trend follower, it’s vital to spot the patterns that repeat over and over again. This is why it’s important to know how to use chart analysis. When you see a pattern on a chart, it’s safe to assume it will repeat (human behavior doesn’t change).
So, let’s say you find a trade opportunity that can work and has a high probability of success. Is it the right trade at this time?
An example of how to use chart analysis
Last week, Josh, one of our sharpest traders in the chat room, put out a trade on Amazon. He was long some (expensive) calls on Thursday, the day Amazon rose sharply by 4%. Josh made a nice profit and was looking for more. The stock had a ton of momentum behind it; it closed up at 1868 and seemed ready to pour it on over the coming days.
Josh decided to spread out the trade and sell an upside call expiring the next day for about $1. His strategy was to sell this call against his long call to create a diagonal spread. Essentially, he would take risk out of the long call by taking in a little premium. On paper, it appeared to be a high probability, low risk trade.
With the momentum Amazon had on December 26, who knew how far this stock would run in the short term. That technicals were impressive: strong volume above the 200 ma. The stock closed at a high for the session.
So, what’s the problem? This strong day came out of nowhere. The trouble with Josh’s trade was not that the trade wouldn’t work. The trouble is that it would play with his mind. When markets scramble your strategy, it’s easy to make mistakes.
Josh could possibly see the short call rise to $3, $4 or $5 without coming close to the strike. He could become very uncomfortable and make a panic buy. A 3% move higher for Amazon is equal to $55. This could scare Josh to the point where he closes the short at a big loss (by buying it back higher) rather than letting it decay.
In sum, Josh was not expecting a substantial move higher. It was the right trade, but it wasn’t a good one.
If you’d like to sharpen your skills and learn how to use chart analysis in 2020, consider joining our Explosive Options chart service. Learn more about it here.