Mastering Derivatives: Keep your analysis simple

Technological development and cheaper computing power has arguably made investment analysis more complex. Take options trading. You have charts showing a comparison of open interest for various strikes for a given expiry. Then, there is the volatility skew graph, statistics showing the probability of an option ending in-the-money (ITM) and real-time graphs of option prices. Typically, more the tools you use, the greater the difficulty in arriving at a conclusion on the trade setup. This week, we discuss how to keep your analysis simple.

Directional bets

Your analysis must start with a view on the underlying. So, first read the underlying’s chart pattern. If the pattern is convincing, taking a bet on futures may be more optimal than options, as the former moves one-to-one with the underlying. If you intend to trade futures, you must check the futures price chart. If you plan to trade options, use the underlying price chart. Your analysis of the price chart must help determine the entry price, the target price, and the stop-loss level for the trade.

Once you have determined whether to buy futures or options, the next step is to choose the contract to trade. Choose the near-month contract for futures. For options, your choice of strike (near-week or near-month expiry) must depend on the option’s liquidity. If you want to keep the analysis simple, then select three strikes — the immediate out-of-the-money (OTM) and two strikes above it. You must choose the one that has the maximum change in open interest, as this metric is a good indication of liquidity. If you want to setup a spread position, then choose the short strike above the resistance level for a bull call spread or below the support level for a bear put spread. 

The above discussion shows that your view on the underlying is the most important factor. The more confident you are about reading chart patterns, the less you need additional tools to set up a strategy. This is not to suggest that the additional tools are unnecessary. It would be useful as a way of providing greater conviction on the trade, but be mindful that that they could provide conflicting signals.

The above argument is only for directional bets. What if you want to setup volatility trades? You need to have a view on volatility as well. For this, you must know where the current implied volatility is in relation to the immediate past volatility. So, past data on implied volatility will help. But if you are an active trader, you will “know” whether the current implied volatility is high or low. 

Take note

It is best if you read chart patterns using just price and volume, not with multiple indicators

Optional reading

It is best if you read chart patterns using just price and volume, not with multiple indicators. It is not that indicators are not useful, but remember they are derived from prices. Besides, if you use multiple indicators, some of them could give conflicting signals. Keep your price charts uncluttered and your analysis simple.

The author offers training programmes for individuals to manage their personal investments

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