Mastering Derivatives: Options for a star reversal

Japanese candlesticks are visually appealing to understand whether the bulls or the bears won the battle in the market on a given day. You can also use candlesticks to discern cues about trend reversals. This week, we look at two such patterns and why options trading is optimal for such reversals.

Bear reversals

Suppose you see signs of weakness in a downtrend — a bear exhaustion, which means the underlying may soon move up, albeit marginally. Two candlestick patterns that could indicate such reversals are morning star and doji.

Consider morning star, a three-candlestick pattern. Suppose there is a continual decline in the underlying price and, say, the last red candle was printed on Monday. And then, a green candle is printed on Tuesday. This candle is small, with its body well below the body of Monday’s red candle. On Wednesday, you see another green candle with a large body, whose high is nearly the same as Monday’s red candle. This three-candlestick formation (Monday to Wednesday) could be an indication that the bulls may be slowly regaining power. You can initiate an options trade on Wednesday when the underlying price moves above Tuesday’s high.

Now, consider doji, a candle that looks like a cross. This suggests that the day’s opening and closing prices were the same or nearly the same, an indication that the bulls and bears had an equal fight. Suppose you observe a series of red candles indicating bear dominance. Then, you see a doji. This could be the first sign of bear exhaustion. Assume the doji was printed on Tuesday. A large green candle on Wednesday provides conviction that the bulls are regaining power. You can initiate an order when the underlying price moves above the high of Tuesday’s candle.

A morning star is a more powerful trend reversal pattern than a doji. It may be optimal to trade options than futures for either of these reversal patterns. Why? In both cases, a series of red candles drives demand for puts than calls. Therefore, puts will be traded at higher implied volatility than calls. Importantly, calls may not have fully factored in a possible reversal after a morning star or a doji. So, you may be able to buy calls at lower implied volatility (cheap).

Take note

A morning star is a more powerful trend reversal pattern than a doji

Optional reading

The call option’s delta will increase as the underlying moves up. Its implied volatility will increase with increase in demand for the strike. Though futures price will move almost one-to-one with the underlying, a failure of a trend reversal could lead to large losses. You should, therefore, wait for the price to break and close above the last (Monday’s) red candle before going long on futures. Trading options gives you an early entry. You need a strict stop loss on options, given the aggressive entry. Your stop should be the low of the morning star or the doji candle formed on the underlying (futures) when trading equity (index) options.

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

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