When learning how to trade options volume must always be factored in. Volume is the number of shares or contracts that trade over a specific period of time, usually one day. On a chart, volume is represented as a histogram (vertical bars) overlaid on or below the price chart. This indicator is an essential part of every technical formation as a price pattern will typically have a volume pattern attached to it. In other words, we use it to confirm trends and chart patterns. If a stock is truly in an uptrend, we would expect the volume to also be in a similar pattern. This will increase the chances of the trend continuing. Any price movement up or down with relatively high volume is seen as stronger and more reliable than a similar move on weak volume. The same guideline holds for changes in the MACD and stochastic oscillators. If we see positive or negative signals in these indicators, they are more significant on high volume and less so on low volume.
Some chartists will draw a trendline on volume and compare it to the trends of price and other technical indicators. If they are not moving in the same direction, we have a negative volume divergence. For example, if price is rising and volume is declining, there could be a trend reversal on the horizon. On the other hand, if price is declining and volume is accelerating, this negative trend is confirmed and a sell signal is more meaningful. Such an example can be found in the chart below:
- The red arrows highlight strengthening volume
- The blue arrows show a declining price trend
- Volume is also confirming a negative MACD divergence (green circles)
- Volume is also confirming a negative stochastic oscillator divergence (red circles)
In the chart below, we have an example of a negative volume divergence, demonstrating a potential trend reversal:
- Red arrows highlight volume confirmation of price acceleration
- Blue lines show weakening volume and price consolidation (sideways pattern)
- The green arrow shows a severe price reversal with volume confirmation (green circle) as the volume bars are much higher than during consolidation.
Technicians who look for specific chart patterns such as triangles, flags and head and shoulders can also utilize volume patterns to confirm the accuracy of these patterns. Another important concept in technical analysis is that volume precedes price. If volume is weakening during an uptrend, it is oftentimes a signal that the trend is about to reverse.
Putting it all together with FFIV:
At the start of the March contracts I bought FFIV @ $125.56. Although the chart pattern was still bullish the confirming technicals were turning bearish. In addition, volume was declining indicating a possible trend reversal. In situations like this I will oftentimes write ITM strikes and allow the option buyer to “pay for” an insurance policy in case the price begins to trend down. I sold the March $120s for $8.62 for a 2.6%, 1-month return with downside protection OF THAT PROFIT of 4.4%. On March 1st the $120 call was trading @ parity (all intrinsic value) as the stock approached $128 so I closed my total covered call position and used the cash to open a new position with a different stock. As it turned out, I didn’t need the downside protection. But the decision I made initially was based on sound fundamental, technical and common sense principles and I still found a way to enhance my already maximized returns. Here is the chart of FFIV as of March 2nd:
Volume is an essential technical analysis tool that will verify the significance of a price pattern or technical analysis indicator confirmation or divergence. It can also be predictive of upcoming changes in chart patterns. We use volume to corroborate buy/sell signals. A positive or negative signal on high volume is much more significant than one on low volume. Volume surges (1.5 x normal volume) are especially significant.
The Elite Calculator:
We have made a minor change to how we calculator short-term percentage returns in the “unwind now” tab of the expanded version of the Ellman Calculator. Previously we deducted the option premium from our cost basis as would be done for tax purposes when a position is closed. This approach is not intuitive to many of our members including me. Although the resulting change in miniscule we feel that a case can be made for either approach so we now opt for the one that makes the most mathematical sense. In the example cited in the user guide the % return will change from a 2-week return of 1.8% to 1.74%. Our premium members can access this enhanced version of the Elite Calculator in the “resources/downloads” section of your premium site (“Elite Calculator 2012”). We are also working on updating the Schedule D to reflect the new tax laws. I will send out an email to our premium members and post on this blog when those enhancements have been completed and available to you.
This week’s reports reflected a stable’and slowly growing economy:
- The Conference Board’s index of consumer confidence beat expectations (63), rising more than 9 points to 70.8 in February
- Durable goods orders dropped 4.0% in January more than anticipated (-1%)
- Annualized growth in 4th quarter GDP was revised upward to 3.0% from the advanced estimate of 2.8%
- The Federal Reserve’s Beige Book showed improving economic conditions between January and early February with manufacturing a standout in all 12 districts
- Personal income increased by 0.3% in January, less than expected (0.4%)
- Consumer spending in January was up 0.2% but less than the 0.4% predicted
- The ISM gauge for manufacturing activity read 52.4 showing continued expansion but less than anticipated
For the week, the S&P 500 was up 0.3% for a year-to-date return of 9.7% including dividends.
The technicals of the S&P 500 and the CBOE Volatility Index (VIX) continue to impress: