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If you – like so many options traders – time entry and exit on a series of signals, then you already know that false signals appear. Confusing reversal with retracement, for example, is common. And even the strongest signals may be only coincidences of price pattern. Following are some suggestions for identifying when signals might be false and should lead to caution in timing of trades. Always require confirmation Many traders, wanting to make a perfectly timed trade, forget to look for confirmation. A true reversal must be confirmed with a second signal indicating the same likely reversal to follow. False signals are common because short-term price behavior is chaotic. Even strong signals can be misleading and confirmed signals also fail. But to minimize poorly timed trades, signal and confirmation are essential as a starting point. Don’t limit your use of confirming signals. Most traders have a short list of favorite signals. This develops from past success and makes sense. But it can also lead to a failure to see a reversal. Be willing to consider signals beyond your short list, and to rely on a broad range of possible confirmation indicators. Move beyond price indicators as well. Check volume, moving averages, and momentum oscillators to find additional confirmation beyond price. Even for price signals, check both traditional Western technical price signals (violations of resistance or support, big gaps, double tops and bottoms, island reversals) as well as Eastern technical signals (candlesticks). Avoid confirmation bias One of the most chronic problems traders face is confirmation bias, seeing what we want to see but ignoring contrary information. This occurs because all traders are humans, and we all want to perfect the science of chart reading. However, if you focus only on the science and ignore the equally important art of chart reading, you could fall into the confirmation bias trap. This happens when you believe that reversal is underway, and you want to time your options trade (either entry or exit) as accurately as possible. As a result, you find reversal signals even when they are weak or are contradicted by other price activity (such as continuation signals). A rational approach is to resist confirmation bias and analyze what the signals reveal; be aware that wanting to be perfect in timing can lead to errors. Lack of confirmation is a sign that you might be looking at retracement Some traders see an initial signal and think it represents a reversal. For example, price has moved strongly to the upside but has reached a plateau and is beginning to decline. An initial reversal is located, but there appears to be no confirmation in price, moving averages, volume or momentum. The lack of confirmation for initial reversal signals is one symptom of retracement. This momentary movement in price may be a passing attribute of price behavior, regression toward the mean rather than the more dramatic directional change. Retracement and reversal appear identical at first glance but knowing the difference can save you from a poorly-timed decision. Be a contrarian Is everyone acting in the same manner? If the crowd believes price is about to turn and move in the opposite direction, it could be a good time to act as a contrarian. Apply logic and not emotion to the timing of trades. The talking heads on financial TV shows reflect the popular view, which is not always the right view. Remember that timing is not perfect Even when you find a reversal and confirmation, it does not mean the change in direction will be immediately. Traders often are frustrated because a strong reversal and confirmation is identified, but price does not respond. It could be several days, perhaps even a week or more, before the reversal takes hold. Don’t change default settings for the wrong reasons Default settings in online charting services are set for a reason. For example, Relative Strength Index (RSI) is set for a 14-day average. Some traders like to change this by reducing the averaging period, usually on the rationale that this produces more overbought or oversold signals. The flaw in this thinking is that more signals are not reliable. In any chart, you will discover that changing the RSI default produces numerous false signals. The 14-day average works and yields the right number of signals. Some default settings can be changed to improve your reading. For example, Bollinger Bands sets upper and lower levels at two standard deviations from the middle band. Violations of the upper and lower bands tend to be short-lived and of great value in spotting likely reversal. If the default is changed to three standard deviations, most charts show no violations of the bands. However, when violations do occur, the return to a previous range is as close to 100% certainty within a day or two, so this is an excellent system for spotting reliable reversal timing. Resist impatience Options traders tend to be analytical and like using a range of signals. But this can also become a trap. At some point, you must act. In fact, at some point, you need to convert reliance on signals and depend to some degree on intuition. However, a greater problem for many traders is impatience. Options traders like to be in the game, so a tendency is to want a trade even when the signals are not strong or, perhaps, do not even exist. Avoid making trades in anticipation of reversal at mid-range and acknowledge that reversal is more likely when price is near resistance or support. If reversal signals are not found and confirmed, don’t make the trade. Wait and be patient. The desire to make a trade can mislead you into believing a signal is there, even when it is not. Every options trader knows this but may easily fail to respond logically to rational analysis. An impatient trader will lose in too many trades. The cold, impartial, analytical contrarian might not make as many trades as others but is more likely to book profits from well-timed options trades. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook. Related articles Island Clusters As Strong Reversals Powerful Channel Signal – Combining Bollinger And T-Line Great Reversal Signal – 50 MA With 8 EMA The Meaning Of Divergent Bars Those Golden And Death Crosses
The attributes are easily spotted on a chart, but it does not appear often. It consists of three specific parts. First, price gaps away from the current trading range, either above or below. The gap itself is significant, but it can mean may things: reversal, continuation, or just momentary volatility. The second attribute is trading in the new range, but only for a limited number of sessions. The “typical” island cluster consists of three to six sessions. Every trader knows that several things can happen next: Continued trading in the new range, movement in the same direction, or movement reversing and going back to the previous range. In other words, at the point of the second phase, you cannot know what will happen next. The third attribute is where a call to action occurs. It consists of a gap in the opposite direction, setting up the cluster. Now there is a limited trading activity set off by gaps on both sides, concluding with price moving back to the previous level. This forecasts a strong trend in the direction of the second gap. An example of this was seen on the chart of Cummins (CMI). In August and September price was stuck in consolidation between $135 and $145 per share. A breakout in late September took price above the consolidation range and led to a strong downtrend in October. Price moved from a high of $152 down to $139 in less than two weeks. Then a gap appeared, moving price further, down to $134. The new low was significant, as it remained below the previous support level during consolidation, of $135 per share. Trading remained in this range, from $135 down to $125 for six sessions. Next, price gapped higher, from a close of about $133 up above $135. In this pattern, creating an island cluster, the signal was clear. Because the price after the gap closed at the previous support price during consolidation, the signal clearly predicted a new bullish move. This is typical after the island cluster. Price tends to move away from the cluster, often strongly, and to either set up a new range, or to remain volatile in the short term. Either event is appealing to options traders. In the example, CMI price did as predicted, moving higher. This is shown in the second chart. This chart extends beyond the timing of the island cluster. The six-day island cluster was visible after the pattern was concluded. As predicted, it took price higher over the following month, moving from $135 to as high as $155. It later plunged back to $125 over the first three weeks of December, then turning bullish once again. The volatility after the conclusion of the island cluster could be disturbing to many equity traders. But to options traders, this situation sets up attractive swing trading possibilities, especially given the overall range between $125 on the low side and $155 on the high side. Trading options at the conclusion of the island cluster is indicated in one of the following ways: Open short calls and open long puts should be closed based on this pattern. As the island cluster ended, the forecast was for a strong move to higher prices. Open short puts and open long calls should be left open due to the pattern. The conclusion of the island cluster predicts price move higher, meaning the open short put will lose value in coming days or weeks and can be bought to close at a profit or allowed to expire worthless. For traders with no open positions, the conclusion of an island cluster indicates new trades that should be opened, and timing is excellent for a bullish move. However, before embarking on any new positions, seek confirmation from a secondary signal. The long white session before the concluding gap, followed by another long white session on the second day after the gap, may be view as bullish confirmation. A bullish trade is indicated when the island cluster occurs to the downside, as in this example. This may consist of selling to open a short put or buying to open a long call. The opposite trades would be indicated when an island cluster occurs above the current range and pointing to the likelihood of a bearish reversal. Timing of trades depends on a trader’s strategic viewpoint. For long options, a one-month time to expiration is likely to work best. Price will not include excessive time value and time decay will not accelerate until the final two weeks of the option’s life. For short options, the idea timing is one week to 10 days. This will include a weekend with following Friday expiration and time decay will be rapid. This means the chances for being able to buy to close at a profit will be at maximum. The weekend is essential in the timing of a short trade. On average, options lose one-third of their remaining time value between he Friday before expiration and the Monday of expiration week. This timing, combined with the exceptional reversal signal provided by the island cluster, is the key element to timing of options trades in this situation. The same overall timing strategy can be applied to any strong signal with confirmation, and timing is as important as proximity in every instance. The idea option trade will be at the money or slightly out of the money (for long) or in the money (for short). These proximity guidelines minimize cost for long positions while keeping the trade close to the strike; and maximize premium income for short positions while setting up the opportunity for profits from rapid time decay – all if price behaves as expected. And this is the element of uncertainty that makes options trading interesting. Manageable risk levels produce profits when reversal and confirmation are recognized … most of the time. However, traders – especially swing traders – also need to be realistic about the possibility that even the strongest signals are misleading at times. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
Michael C. Thomsett posted a article in Trading BlogTo review: Bollinger Bands has three averages. The middle band is a 20-period simple moving average. The upper band and lower band are the second and third parts. Each are two standard deviations away from the middle band. This is a visual summary of historical volatility. Price generally is not likely to trade above the upper band or below the lower band for very long. When price does move outside of these ranges, it retreats back into range very quickly. So BB is like a “probability matrix” for timing entry and exit. The T-line is an 8-day exponential moving average of price that yields surprisingly reliable signals for changes in price direction. The rule is that when price is above the t-line, it remains bullish until it crosses below and closes for at least two sessions. This sets up a bearish reversal. When price is below the t-line, the prevailing bearish trend continues until price crosses above and closes above for at least two consecutive sessions. Taken apart, BB and the t-line are powerful on their own. However, when used in combination, you set up a very powerful dynamic trading range, making it easy to spot when a trend ends. As price advance, the BB upper band represents resistance and the t-line is support. When prices are moving down, the t-line is resistance and the BB lower band is support. The chart for Cummins (CMI) shows the reversal signals this combination highlights. The combined signal sets up the narrow channel based on whether price trend is bullish or bearish. In a bullish trend, the upper Bollinger Band is rising resistance and the t-line (red on the chart) is rising support. The bullish trend continues until price crosses below the t-line and closes there for two consecutive sessions. In a bearish trend, the t-line represents declining resistance and the lower Bollinger Band is declining support. The bearish trend continues until price crosses above the t-line and closes above for two consecutive sessions. The CMI chart shows how this works. In May, price had been declining down to as low as $140 per share. But at mid-month, price crossed above the t-line (the red line), demonstrating that the downtrend, for the moment at least, was ending. At the beginning of July, a further decline ended when price again moved across the t-line and marked the beginning of a gradual advance. The combination of Bollinger Bands and t-line is so reliable that it can be used effectively in two ways. First, it distinguishes between retracement (not moving across the t-line) and reversal. Second, actual crossover is the signal point for leaving a current trade and taking profits, or for entering a new trend based on the newly revised price direction. This solves the most disturbing aspect of short-term options trading. When do you enter and exit a trade? Even with the lack of clear reversal signals, the combined use of BB and the t-line is a powerful and reliable system to improve timing. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
This assumes your timing is made more reliable by selecting long or short positions in close proximity to resistance and support, and that the moneyness of the option also is considered. For short positions, focus on high volatility and very short time to expiration. For long positions, seek low volatility and a balance between cost and time. The combined signals recommended for better than average timing are the combined 50-day moving average (MA) and the 8-day exponential moving average (which also is called the t-line). The combination of these two can be used to generate a trade based on crossover, and confirmed with secondary price signals. For example, the six-month chart of Caterpillar (CAT) reveals two strong examples of crossover between the two priced averages, and confirmation in candlestick reversals. In both instances, the predicted bullish reversal occurred. The initial signal is when the 8-day EMA (t-line) crosses below the 50-day MA. This first occurred in the first week of February. This was confirmed by two bullish reversal candlesticks, a bullish engulfing and a bullish harami. The harami too price to the bottom of the downtrend, closing at about $145 per share. At this point, a bullish options trade would have made sense. If a current long put or short call was already open, this was the place to close. If no options were open at this point, it made sense to open a long call or a short put. The subsequent bullish reversal too price up to $162.50 in only two weeks. Any open options could be closed after observing the running gaps at the end of this bullish run. The second occurrence was at the end of April. The same formation of crossover predicted a bullish turn. This was confirmed by an unusually long black candle that formed into a bullish piercing lines signal. This was further confirmed immediately by a bullish meeting lines. This was a mild signal with low daily ranges, but it still worked as confirmation, predicting another bullish run. Opening bullish trades (or closing bearing trades) at this point would be well-timed, as price ran from $142 to $155 in only two weeks. These short-term signals are exceptionally strong. The combination of a 50-MA simple moving average and an 8-day exponential moving average set up reversals via crossover; and as long as you find confirmation, it becomes a reliable timing signal for options trades. The combination provides a secondary benefit as well. The 8-day EMA serves as dynamic support as prices rise, and as declining resistance as prices fall. This tends to be more reliable than the traditional straight-line resistance and support trendlines most traders follow. Another secondary cautionary point: The 8-day trendline tends to give off reversal signals on its own, When this is below price, it indicates a bearish condition, and when above, the signal is bullish. At the conclusion of this chart, the 8-day EMA is below price, predicting a likely retracement to the downside. This is confirmed by another crossover, the move of the 50-day MA below the 8-day EMA. This confirms a likely bearish move to occur next. Both of these moving averages are lagging indicators, so they have to be accepted with caution. This is why candlestick confirmation adds confidence to any reversal signal. However, even lagging indicators are of value in trading options, when used together as crossover set-up for confirmation, as seen on the CAT chart. Any help options traders can get from price signals like these, is worth keeping on the chart. Once a position is opened, look for the warning signs that a favorable trend is ab out to level out or reverse. Once an option has been closed, look for potential reversal points to enter a new position and take advantage of a reversal. There is no such thing as a “perfect” signal, and no one will get 100% perfect timing. But using two or more signals together like these two moving averages, improves your overall timing and profits in entering and exiting options positions. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.