If I tell you that I love to trade options on one particular stock, which one do you think it is?
Odds are you are picturing a stock that continually trades higher, a stock that makes higher highs and higher lows, a stock that regularly beats analyst expectations and gets a big boost when it reports stellar earnings, a stock that’s been rising more or less with the markets for the past six years.
And you’d be right… but only partly right.
Frankly, I don’t care WHICH direction a stock is headed.
I just need it to move…
And this “simple” indicator tells me everything I need in one simple line.
The One Indicator You Need to Spot the Latest Trends
If you’re a beginner, one of the easiest way to pick stocks is to use a moving average to help you get a clear picture of where a stock is headed.
A moving average is a simple technical analysis tool that gives you the average price data of a stock or ETF over a specific time period (you can tailor it to whatever timeframe you like, making it a good tool for both short-term and long-term trades).
There are two types of moving averages: Simple and Exponential.
The Simple Moving Average is calculated by adding up the prices and dividing by the number. So to find a 50-Day SMA, you add up the last 50 prices and divide by 50. The Exponential Moving Average is a bit more complex, as more recent prices are weighted more heavily in the calculations (it also tends to react quicker because of this weighting).
For our purposes here, we’re going to use the Simple Moving Average so you can follow along without having to do any complicated math.
As I’ll show you in a moment, using a moving average cuts out a lot of the static on a price chart and helps you focus in on a stock’s overall trend rather than its intraday ups and downs.
You’ll also see – and this is key – that a moving average can also represent a stock’s support or resistance levels in a given timeframe. That gives you a good idea of a stock’s recent floor and ceiling
When you’re trading options, you can use moving averages to spot trends, determine whether to buy calls or puts, figure out which strike prices you want to target, and how long – based on the price action in the moving average – it will take for the stock to move enough for your options to become profitable.
Let me give you three examples.
A “Great Stock to Trade Options On”
When I talk about a “great stock to trade options on,” you’re probably picturing a stock chart that looks something like this:
The markets – meaning the Dow, NASDAQ and S&P – have gone through a pretty hefty recent selloff. Even the strongest of bullish trending stocks got caught up in it, as you see with Nike Inc. (NYSE:NKE).
The 200-Day Simple Moving Average gives you immediate visual confirmation that NKE is in a steady upward trend, trading higher for the majority, if not all, of 2015.
That is a nice trend and means that trading NKE with bullish strategies – buying simple calls, or even a bullish loophole trade – should have traders seeing profits for the year.
Let me now show you another chart, this time for ConocoPhillips (NYSE:COP).
As you can see, it has been in a lengthy and consistent down trend for about five months.
The 200-Day SMA confirms this, cutting out all the visual noise in COP’s actual price chart. Notice that the stock bounced up from around the 60 level in late February/early March, getting to nearly 70 before sliding steadily to a low of nearly 40 in late August.
But the SMA allows us to see this in a simple, straight line – the price has trended down for most of 2015.
From the looks of this chart then, COP would have been a great candidate for some bearish options strategies.
Let me show you one more chart.
Citigroup Inc. (NYSE:C) looks choppy and doesn’t have that clear up or down trend or at least it is not as smooth a directional trend as the prior two stock charts.
You might think that this isn’t a great stock to trade options on. But these repeatable price point swings actually help you predetermine future price moves and the time it takes to make them. Look closely and you can see that when Citigroup makes a larger price move up, it makes about an equal price move back down.
And take a look at the 200-Day Simple Moving Average and how it reacts to that. It worked as a support point for it for quite a while and now it may be resistance like it was on its recent retrace up.
Now, I am not recommending these as great investments, nor am I recommending you go right out and start trading these particular stocks – they are simply examples of how you can use a Moving Average to spot trends that may give you an idea of how a stock’s price is going to move.
Watch Out For Your Own Directional Bias
A lot of beginning and intermediate traders come from a strict “buy and hold” philosophy that requires their investments to rise in value in order for them to make money.
And that philosophy can color every trade they make – the idea that a stock must go higher for them to make money is so ingrained in their psyche that when they start to trade options, they don’t have a lot of success.
A great stock to trade options on is a stock that trades in any of these three trends – up, down or sideways. As I’ve said before, a trader really shouldn’t have a vested interest in which directions the stock goes… the trader just needs the stock to GO!
My job is to condition you to not impose your own directional bias on a stock chart. That mindset can lead you to miss out on opportunities on the trend or move it is making.
Learn to read the indicators, spot the repeatable patterns, and trade the signals for what they are, not what you want them to be.