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10 Price Action Trading Tips

Ajeet Singh June 30, 2016

1. Avoid trading when the market is far away from the moving average

When the market is trending, it tends to mean revert towards the moving average.
Depending on the type of trend you’re in:
  • In a strong trend, the market tends mean revert to the 20 MA.
  • In a normal trend, the market tends to mean revert to the 100 MA
  • In a weak trend, the market tends to mean revert to 200 MA
Thus, the last thing you want to do is enter a trade when the market is far away from it’s moving average.
Here’s what I mean:

Pro tip:
You need to identify the moving average that is currently being “respected” by the markets.
In a strong trending market, the moving average value is lower, and in weak trending markets, the moving average value is higher.

2. Support & resistance helps you identify areas of value to trade from

You want to buy low and sell high, right?
But the question is:
How do you define what’s low and what’s high?
Allow me to introduce to you…

Horizontal support & resistance

This is useful because it helps you identify areas of value on the chart.
Support – Area on the chart where you’re are looking to buy “low”
Resistance – Area on the chart where you’re looking to sell “high”
Here are a few examples:

Also, moving average helps you identify areas of value in the form of…

Dynamic support & resistance

These are Support & Resistance that moves along with the price.
Dynamic support occurs in an uptrend, and dynamic resistance in a downtrend.
They can be identified using moving averages. (I use 20 & 50 EMA).
This is what I mean…
Pro tip:
In a strong trending market, the price may not pullback towards horizontal support & resistance (which cause a lot of traders to miss the trend).
Instead, they tend to pullback towards dynamic support & resistance, which is an area of value you must pay attention to.

3. Trading at support & resistance gives you favorable risk to reward

Here’s the thing…
If you enter trades in the middle of a range, it never gives you a favorable risk to reward (at best 1 to 1).
An example:
But…
If you enter trades at support & resistance, it would greatly improve your risk to reward.
Here’s what I mean:
Pro tip:
The risk to reward profile is only one side of the equation. The other thing you need to take into account is the probability of your trade working out.

4. The longer it ranges the harder it trends

If there is a sudden range expansion in a market that has been trading narrowly, human nature is to try and fade that price move. When you get range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion. – Paul Tudor Jones
If you notice the price has been ranging for a long time, you’re not alone.
Traders all around the world will be seeing the same charts as you.
Some will be queuing to short the resistance, and some will be trading the breakout.
If the price does trade above the resistance, shorts will get squeezed, and breakout traders will hop on the bandwagon.
That’s why price trend for a sustained period of time, due to the imbalance of buying/selling pressure.
Here are a few examples:
You’re probably wondering:
I don’t have the patience to wait this long. I want to capture big moves in the market, now.
And this is what I’ll cover next…

5. Narrow range candles usually lead to explosive moves

You’ve learnt that the longer price range, the harder it’ll trend. Now, you can take this concept further and apply it to the range of candles (instead of time).
The thing you’re looking out for is… narrow range candles.
Why?
Because you can expect an explosive move to occur soon.
Here are a few examples:
So, when you get series of narrow range candles, get ready for an explosive move.

6. Wide range candles serve as “hidden” support & resistance

A wide range candle is formed due to an imbalance of buying/selling pressure.
This represents “hidden” Support & Resistance in the markets (known as Supply & Demand by Sam Seiden)
Here’s what I mean:
There are traders who swear by Supply & Demand, and some who do just fine, with Support & Resistance.

7. False breakout provides one of the best entry to profit from “trapped” traders

First, let me explain what is a false breakout.
I define false breakout when price breaks support or resistance, only to close back into the range.
Here’s what I mean…
Why is this one of the best times to enter a trade?
Because you’re taking advantage of traders who are being “trapped”.
Imagine:
A trader, called Michael, went long on the break of resistance because he expects a rally.
After a few candles, price traded against him and closed under resistance.
At this point…
Michael is “trapped”. And chances are, there are many traders like Michael, who took the same breakout trade and are “trapped”.
Now, a proficient trader can take advantage of this.
How?
By shorting the false breakout, with expectations that the “trapped” traders would cut their trade, and fuel further price decline.
And this my friend is the power of false breakout.

8. Trading with the trend gives you greater profit potential

A mistake made by many traders is that they become so involved in trying to catch the minor market swings that they miss the major price moves. – Jack Schwager
One of the best ways to improve your trading performance is, trading with the trend (and not against it).
This greatly increases the odds of your trade working out, and gives you a greater profit potential.
Here’s what I mean…

9. Continuation patterns work best in trending markets

You may wonder:
What are continuation patterns?
They’re chart patterns such as flags, pennants, triangles etc.
And…
A big mistake traders make is, to trade these patterns in a range market.
An example:
So, when is the best time to trade continuation patterns?
…
…
…
You guessed it, in a trending market.
An example:

10. How to tell when a trend is ending

These are 3 things I’ll look out for:
  • A “respected” moving average is broken
  • Break of structure
  • Break of trendline
An example:
Let’s look it one by one…
  1. Price broke and closed below the 50 EMA, which was a dynamic support that has been “respected” by the  markets
  2. Price broke and close below the trendline
  3. A new structure low in the market is formed. Now you’ve got a lower high and lower low
When you’ve got all 3 factors lined up, it increases the odds that the trend is over.
Here’s another example:









Brexit

Ajeet Singh June 24, 2016

Bear Call Ladder

Ajeet Singh June 13, 2016

Background

The ‘Bear’ in the “Bear Call Ladder” should not deceive you to believe that this is a bearish strategy. The Bear Call Ladder is an improvisation over the Call ratio back spread; this clearly means you implement this strategy when you are out rightly bullish on the stock/index.
In a Bear Call Ladder, the cost of purchasing call options is financed by selling an ‘in the money’ call option. Further, the Bear Call Ladder is also usually setup for a ‘net credit’, where the cash flow is invariably better than the cash flow of the call ratio back spread. However, do note that both these strategies showcase similar payoff structures but differ slightly in terms of the risk structure.

Strategy Notes

The Bear Call Ladder is a 3 leg option strategy, usually setup for a “net credit”, and it involves –
  1. Selling 1 ITM call option
  2. Buying 1 ATM call option
  3. Buying 1 OTM call option
This is the classic Bear Call Ladder setup, executed in a 1:1:1 combination. The bear Call Ladder has to be executed in the 1:1:1 ratio meaning for every 1 ITM Call option sold, 1 ATM and 1 OTM Call option has to be bought. Other combination like 2:2:2 or 3:3:3 (so on and so forth) is possible.
Let’s take an example – assume Nifty Spot is at 7790 and you expect Nifty to hit 8100 by the end of expiry. This is clearly a bullish outlook on the market. To implement the Bear Call Ladder –
  1. Sell 1 ITM Call option
  2. Buy 1 ATM Call option
  3. Buy 1 OTM Call option
Make sure –
  1. The Call options belong to the same expiry
  2. Belongs to the same underlying
  3. The ratio is maintained
The trade set up looks like this –
  1. 7600 CE, one lot short, the premium received for this is Rs.247/-
  2. 7800 CE, one lot long, the premium paid for this option is Rs.117/-
  3. 7900 CE, one lot long, the premium paid for this option is Rs.70/-
  4. The net credit would be 247-117-70 = 60
With these trades, the bear call ladder is executed. Let us check what would happen to the overall cash flow of the strategies at different levels of expiry.
Do note we need to evaluate the strategy payoff at various levels of expiry as the strategy payoff is quite versatile.
Scenario 1 – Market expires at 7600 (below the lower strike price)
We know the intrinsic value of a call option (upon expiry) is –
Max [Spot – Strike, 0]
The 7600 would have an intrinsic value of
Max [7600 – 7600, 0]
= 0
Since we have sold this option, we get to retain the premium received i.e Rs.247/-
Likewise the intrinsic value of 7800 CE and 7900 CE would also be zero; hence we lose the premium paid i.e Rs.117 and Rs.70 respectively.
Net cash flow would Premium Received – Premium paid
= 247 – 117 – 70
= 60
Scenario 2 – Market expires at 7660 (lower strike + net premium received)
The 7600 CE would have an intrinsic value of –
Max [Spot – Strike, 0]
The 7600 would have an intrinsic value of
Max [7660 – 7600, 0]
= 60
Since the 7600 CE is short, we will lose 60 from 247 and retain the balance
= 247 – 60
= 187
The 7800 and 7900 CE would expire worthless, hence we lose the premium paid i.e 117 and 70 respectively.
The total strategy payoff would be –
= 187 – 117 – 70
= 0
Hence at 7660, the strategy would neither make money nor lose money. Hence this is considered a (lower) breakeven point.
Scenario 3 – Market expires at 7700 (between the breakeven point and middle strike i.e 7660 and 7800)
The intrinsic value of 7600 CE would be –
Max [Spot – Strike, 0]
= [7700 – 7600, 0]
= 100
Since, we have sold this option for 247 the net pay off from the option would be
247 – 100
= 147
On the other hand we have bought 7800 CE and 7900 CE, both of which would expire worthless, hence we lose the premium paid for these options i.e 117 and 70 respectively –
Net payoff from the strategy would be –
147 – 117 – 70
= – 40
Scenario 4 – Market expires at 7800 (at the middle strike price)
Pay attention here, as this is where the tragedy strikes!
The 7600 CE would have an intrinsic value of 200, considering we have written this option for a premium of Rs.247, we stand to lose the intrinsic value which is Rs.200.
Hence on the 7600 CE, we lose 200 and retain –
247 – 200
= 47/-
Both 7800 CE and 7900 CE would expire worthless, hence the premium that we paid goes waste, i.e 117 and 70 respectively. Hence our total payoff would be –
47 – 117 – 70
= -140
Scenario 5 – Market expires at 7900 (at the higher strike price)
Pay attention again, tragedy strikes again ☺
The 7600 CE would have an intrinsic value of 300, considering we have written this option for a premium of Rs.247, we stand to lose all the premium value plus more.
Hence on the 7600 CE, we lose –
247 – 300
= -53
Both 7800 CE would have an intrinsic value of 100, considering we have paid a premium of Rs.117, the pay off for this option would be –
100 – 117
= – 17
Finally 7900 CE would expire worthless, hence the premium paid i.e 70 would go waste. The final strategy payoff would be –
-53 – 17 – 70
= -140
Do note, the loss at both 7800 and 7900 is the same.
Scenario 6 – Market expires at 8040 (sum of long strike minus short strike minus net premium)
Similar to the call ratio back spread, the bear call ladder has two breakeven points i.e the upper and lower breakeven. We evaluated the lower breakeven earlier (scenario 2), and this is the upper breakeven point. The upper breakeven is estimated as –
(7900 + 7800) – 7600 – 60
= 15700 – 7600 – 60
= 8100 – 60
= 8040
Do note, both 7900 and 7800 are strikes we are long on, and 7600 is the strike we are short on. 60 is the net credit.
So at 8040, all the call options would have an intrinsic value –
7600 CE would have an intrinsic value of 8040 – 7600 = 440, since we are short on this at 247, we stand to lose 247 – 440 = -193.
7800 CE would have an intrinsic value of 8040 – 7800 = 240, since we are long on this at 117, we make 240 – 117 = +123
7900 CE would have an intrinsic value of 8040 – 7900 = 140, since we are long on this at 70, we make 140 – 70 = +70
Hence the total payoff from the Bear Call Ladder would be –
-193 + 123 + 70
= 0
Hence at 8040, the strategy would neither make money nor lose money. Hence this is considered a (upper) breakeven point.
Do note, at 7800 and 7900 the strategy was making a loss and at 8040 the strategy broke even. This should give you a sense that beyond 8040, the strategy would make money. Lets just validate this with another scenario.
Scenario 7 – Market expires at 8300
At 8300 all the call options would have an intrinsic value.
7600 CE would have an intrinsic value of 8300 – 7600 = 700, since we are short on this at 247, we stand to lose 247 – 700 = -453.
7800 CE would have an intrinsic value of 8300 – 7800 = 500, since we are long on this at 117, we make 500 – 117 = +383
7900 CE would have an intrinsic value of 8300 – 7900 = 400, since we are long on this at 70, we make 400 – 70 = +330
Hence the total payoff from the Bear Call Ladder would be –
-453 + 383 + 330
= 260
As you can imagine, the higher the market move, the higher is the profit potential. Here is a table that gives you the payoffs at various levels.
Do notice, when the market goes below you stand to make a modest gain of 60 points, but when the market moves up the profits are uncapped.

Strategy Generalization

Going by the above discussed scenarios we can make few generalizations –
  • Spread = technically this is a ladder and not really a spread. However the 1st two option legs creates a classic “spread” wherein we sell ITM and buy ATM. Hence the spread could be taken as the difference between the ITM and ITM options. In this case it would be 200 (7800 – 7600)
  • Net Credit = Premium Received from ITM CE – Premium paid to ATM & OTM CE
  • Max Loss = Spread (difference between the ITM and ITM options) – Net Credit
  • Max Loss occurs at = ATM and OTM  Strike
  • The payoff when market goes down = Net Credit
  • Lower Breakeven = Lower Strike + Net Credit
  • Upper Breakeven = Sum of Long strike minus short strike minus net premium
Here is a graph that highlights all these important points –

Notice how the strategy makes a loss between 7660 and 8040, but ends up making a huge profit if the market moves past 8040. Even if the market goes down you still end up making a modest profit. But you are badly hit if the market does not move at all. Given this characteristics of the Bear Call Ladder, I would suggest you implement the strategy only when you are absolutely sure that the market will move, irrespective of the direction.
From my experience, I believe this strategy is best executed on stocks (rather than index) when the quarterly results are due.


Call Ratio Backspread

Ajeet Singh June 12, 2016

Background

The Call Ratio Back Spread is an interesting options strategy. I call this interesting keeping in mind the simplicity of implementation and the kind of pay off it offers the trader. This should certainly have a spot in your strategy arsenal. The strategy is deployed when one is out rightly bullish on a stock (or index), unlike the bull call spread or bull put spread where one is moderately bullish.
At a broad level this is what you will experience when you implement the Call Ratio Back Spread-
  1. Unlimited profit if the market goes up
  2. Limited profit if market goes down
  3. A predefined loss if the market stay within a range
In simpler words you can get to make money as long as the market moves in either direction.
Usually, the Call Ratio Back Spread is deployed for a ‘net credit’, meaning money flows into your account as soon as you execute Call Ratio Back Spread. The ‘net credit’ is what you make if the market goes down, as opposed to your expectation (i.e market going up). On the other hand if the market indeed goes up, then you stand to make an unlimited profit. I suppose this should also explain why the call ratio spread is better than buying a plain vanilla call option.
So let’s go ahead and figure out how this works.

Strategy Notes

The Call Ratio Back Spread is a 3 leg option strategy as it involves buying two OTM call option and selling one ITM Call option. This is the classic 2:1 combo. In fact the call ratio back spread has to be executed in the 2:1 ratio meaning 2 options bought for every one option sold, or 4 options bought for every 2 option sold, so on and so forth.
Let take an example – assume Nifty Spot is at 7743 and you expect Nifty to hit 8100 by the end of expiry. This is clearly a bullish outlook on the market. To implement the Call Ratio Back Spread –
  1. Sell one lot of 7600 CE (ITM)
  2. Buy two lots of 7800 CE (OTM)
Make sure –
  1. The Call options belong to the same expiry
  2. Belongs to the same underlying
  3. The ratio is maintained
The trade set up looks like this –
  1. 7600 CE, one lot short, the premium received for this is Rs.201/-
  2. 7800 CE, two lots long, the premium paid is Rs.78/- per lot, so Rs.156/- for 2 lots
  3. Net Cash flow is = Premium Received – Premium Paid i.e 201 – 156 = 45 (Net Credit)
With these trades, the call ratio back spread is executed. Let us check what would happen to the overall cash flow of the strategies at different levels of expiry.
Do note we need to evaluate the strategy payoff at various levels of expiry as the strategy payoff is quite versatile.
Scenario 1 – Market expires at 7400 (below the lower strike price)
We know the intrinsic value of a call option (upon expiry) is –
Max [Spot – Strike, 0]
The 7600 would have an intrinsic value of
Max [7400 – 7600, 0]
= 0
Since we have sold this option, we get to retain the premium received i.e Rs.201
The intrinsic value of 7800 call option would also be zero; hence we lose the total premium paid i.e Rs.78 per lot or Rs.156 for two lots.
Net cash flow would Premium Received – Premium paid
= 201 – 156
= 45
Scenario 2 – Market expires at 7600 (at the lower strike price)
The intrinsic value of both the call options i.e 7600 and 7800 would be zero, hence both of them expire worthless.
We get to retain the premium received i.e Rs.201 towards the 7600 CE however we lose Rs.156 on the 7800 CE resulting in a net payoff ofRs.45.
Scenario 3 – Market expires at 7645 (at the lower strike price plus net credit)
You must be wondering why I picked the 7645 level, well this is to showcase the fact that the strategy break even is at this level.
The intrinsic value of 7600 CE would be –
Max [Spot – Strike, 0]
= [7645 – 7600, 0]
= 45
Since, we have sold this option for 201 the net pay off from the option would be
201 – 45
= 156
On the other hand we have bought two 7800 CE by paying a premium of 156. Clearly the 7800 CE would expire worthless hence, we lose the entire premium.
Net payoff would be –
156 – 156
= 0
So at 7645 the strategy neither makes money or loses any money for the trader, hence 7645 is treated as a breakeven point for this trade.
Scenario 4 – Market expires at 7700 (half way between the lower and higher strike price)
The 7600 CE would have an intrinsic value of 100, and the 7800 would have no intrinsic value.
On the 7600 CE we get to retain 101, as we would lose 100 from the premium received of 201 i.e 201 – 100 = 101.
We lose the entire premium of Rs.156 on the 7800 CE, hence the total payoff from the strategy would be
= 101 – 156
= – 55
Scenario 5 – Market expires at 7800 (at the higher strike price)
This is an interesting market expiry level, think about it –
  1. At 7800 the 7600 CE would have an intrinsic value of 200, and hence we have to let go of the entire premium received i.e 201
  2. At 7800, the 7800 CE would expire worthless hence we lose the entire premium paid for the 7800 CE i.e Rs.78 per lot, since we have 2 of these we lose Rs.156
So this is like a ‘double whammy’ point for the strategy!
The net pay off for the strategy is –
Premium Received for 7600 CE – Intrinsic value of 7600 CE – Premium Paid for 7800 CE
= 201 – 200 – 156
= -155
This also happens to be the maximum loss of this strategy.
Scenario 6 – Market expires at 7955 (higher strike i.e 7800 + Max loss)
I’ve deliberately selected this strike to showcase the fact that at 7955 the strategy breakeven!
But we dealt with a breakeven earlier, you may ask?
Well, this strategy has two breakeven points – one on the lower side (7645) and another one on the upper side i.e 7955.
At 7955 the net payoff from the strategy is –
Premium Received for 7600 CE – Intrinsic value of 7600 CE + (2* Intrinsic value of 7800 CE) – Premium Paid for 7800 CE
= 201 – 355 + (2*155) – 156
= 201 – 355 + 310 – 156
= 0
Scenario 7 – Market expires at 8100 (higher than the higher strike price, your expected target)
The 7600 CE will have an intrinsic value of 500, and the 7800 CE will have an intrinsic value of 300.
The net payoff would be –
Premium Received for 7600 CE – Intrinsic value of 7600 CE + (2* Intrinsic value of 7800 CE) – Premium Paid for 7800 CE
= 201 – 500 + (2*300) – 156
= 201 – 500 + 600 -156
= 145
Here are various other levels of expiry, and the eventual payoff from the strategy. Do note, as the market goes up, so does the profits, but when the market goes down, you still make some money, although limited.

Strategy Generalization

Going by the above discussed scenarios we can make few generalizations –
  • Spread = Higher Strike – Lower Strike
  • Net Credit = Premium Received for lower strike – 2*Premium of higher strike
  • Max Loss = Spread – Net Credit
  • Max Loss occurs at = Higher Strike
  • The payoff when market goes down = Net Credit
  • Lower Breakeven = Lower Strike + Net Credit
  • Upper Breakeven = Higher Strike + Max Loss
Here is a graph that highlights all these important points –

Notice how the payoff remains flat even when the market goes down, the maximum loss at 7800, and the way the payoff takes off beyond 7955.


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