This is a problem of great magnitude. The mere volume of data produced daily is staggering. According to The Visual Capitalist, every day sees 500 million tweets and 294 billion emails. About 5 billion online searches are made, and by 2025 an estimate is that 463 exabytes of data will be created around the world. That’s over 212 million DVDs … every day.
What exactly is an exabyte? It’s equivalent of 1,0006 bytes and is written as the unimaginable number 1,000,000,000,000,000,000,000,000. Many of us can remember the old days when we thought that 64k (64 kilobytes, or 1,000 bytes) was big. But as the ability to create, manage and transmit data grows every day, the entire world of data is changing.
For options traders, this has a serious ramification. If you make trades based on data you collect about a stock, historical and implied volatility, current news, stock charts, and analysts’ opinions, you’re in deep water. You could drown in the data.
How do you know which data sources are accurate and which are not? It is not an easy task and there is no easy or authoritative answer to the question. It would be naïve to assume that because we rely on data, we are being smart. By timing entry or exit in an option position, based on data about probability, volatility and history, are we using reliable data?
Do we reject past methods due to the troubling level of information and our inability to filter the goof from the bad? If we must reject the methods of the past, what do we replace it with? How do we filter data to ensure that what we do use is reliable, either on a fundamental or a technical basis?
It seems apparent that there is only one way to avoid being drowned in data, including contradictory or inconclusive data. That is to identify a very, very short list of data we can use to time options trades. In the past, options traders might have fallen into the trap of thinking that more data equals better decisions and, of course, that less data equals poorer decisions. In truth, the opposite might be true, if your short list is accurate and reliable.
Here is a short list for the starting point, the fundamentals about the underlying. This is a good starting point assuming you want to trade options on well-managed, profitable companies, and all tests should be performed over 10 years:
Dividends per share (looking for dividends to rise every year, which defines the company as a “dividend achiever.”
Dividend yield at 3.5% or higher.
Debt-to-capitalization ratio that is steady or declining. (High dividends are misleading if accompanied with rising long-term debt, so this test is connected directly to tests 1 and 2).
Annual P/E range between 10 and 25 with few exceptions. (Current P/E is not reliable because it compares current price to outdated earnings; annual ranges are more revealing.)
- Consistent and rising annual revenues and net profit; and steady net return.
Options traders who limit their strategies to companies qualifying for this short list of fundamentals are likely to experience lower than average volatility and consistency of returns. However, going along with this is a short list of technical indicators to use for timing of entry or exit. Here is a list of the strongest technical signals to use in timing options trades:
A combination of Bollinger Bands and the t-line. In dynamic moves, the combined use of two indicators sets up a narrow channel. When prices moves outside of the channel, it gives you an exceptionally strong reversal signal. To improve Bollinger Bands even more, change the default to three standard deviations. Price rarely moves above the upper band or below the lower band, and when it does, it will not last longer than one or two sessions. If you are patient in waiting for this signal based on three standard deviations, you will spot the strongest possible reversal forecast.
Island reversals. These are defined as a small number of sessions either above or below the established trading range, identified with a gap before and after. This also sets up an easily observed reversal signal.
Exceptionally strong candlestick reversals. These include morning and evening stars, abandoned baby, three white soldiers, three black crows, hammer and hanging man, to name a few. Recognizing strong candlestick reversals and finding confirmation in other signals, ensures a vastly improved level of timing for options trading.
The volume spike. A lot of volume signals can be set up on free online charts, but the best one is quite visual and a powerful reversal signal. This is a change in the volume of trading far above the average, with volume returning immediately to more typical levels. You often find the volume spike as confirmation of breakout and other changes. For example, after a strong earnings surprise, price may gap above (positive) or below(negative), accompanied by a volume spike. A contrarian strategy is to assume prices will retrace to the previous range within a few sessions, identifying the opportunity to move against the crowd.
- Gaps above resistance or below support. This is perhaps the most basic signal. New trends happen when the current trading range is violated. But when price gaps outside of the range, reversal is more likely than at any other point. This marks the best time to exit an existing option trade or to enter a new one — or both.
Options traders face the same problem as everyone else: being able to tell the difference between the good and the bad in ever-growing levels of information. More is not always better. Past assumptions along these lines have demonstrated that it makes more sense to focus on a very short list of data sources that provide exceptional intelligence about the value of the underlying and about the likelihood of reversal in the current price. In modern options trading, more is not better; less is better.
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.