Options Theory: Trading Options Around Support & Resistance
May 18, 2018
Last Update: July 2021
Today we’re combining options and technical analysis. It’s a match made in trader Heaven and thus delivers happiness and, hopefully, dough – lots of dough. Tackle’s resident wisdom dispenser, Mark, suggested the topic, so I’m running with it.
First, let’s make sure we all understand support and resistance. Then, we’ll talk about ideas for trading options around them. For a more rigorous review of these price thresholds, I suggest reviewing our Technical Analysis 101 video series.
Trading around support and resistance, hereafter referred to as S&R, offers two principal benefits: high probability and attractive risk-reward. When you buy a stock your baseline odds are 50-50. By using a char,t we’re trying to identify situations where the odds have shifted in our favor where we have a greater than 50% chance of being right. S&R offer just such a shift. When a stock is at support, it suggests there’s a greater than 50% chance of the stock rising. The same applies to a stock at resistance; only it’s a greater than 50% chance of falling.
If you’re a skeptic, no worries. The next feature of trading around S&R is pure truth, with little to debate. Deploying trades against these price thresholds offers a low-risk, high-reward opportunity. Suppose we buy a call at support. If we’re wrong, we can exit swiftly on a break of support. If we’re right and the stock travels back to resistance, then we’re looking at a lot of potential upside.
My inner trader just whispered that small risk + large reward = cat’s meow.
To illustrate, consider the following chart of Advanced Micro Devices (AMD). When it was testing support last month, we featured it in our Options Report as a bullish candidate. And just look how it’s bounced!
Now, did we know it would respond with such vigor? Nope. We had no clue. All we knew was it was resting near a pivotal support zone which created a tempting low-risk setup. Here’s a summary of the four ways you can trade around S&R.
- First, enter bullish trades for a bounce off support.
- Second, enter bearish trades when support is broken.
- Third, enter bearish trades for a drop from resistance.
- Fourth, enter bullish trades when resistance is broken.
As for trading options around these thresholds, well you have choices, friends. There isn’t one right strategy when deploying bullish trades around the two setups mentioned above. When AMD rested at support, trader A might have bought a call option while trader B might have sold naked puts. Both strategies are legit and simply offer different risk-reward characteristics.
Some traders elect for more aggressive directional trades on breakouts and more conservative directional plays on support tests. For example, they may buy calls or a bull call spread on a break of resistance, anticipating strong follow-through. And when a stock is testing support which they expect to hold firm they may sell naked puts or bull puts. The first batch of strategies offers more potential reward making them better equipped to maximize the profit potential of a big rally. The second batch offers less reward, but a higher probability in case the stock fiddles around at support.
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