By Carson Dahlberg, CMT

Special to the TradeTech Blog

I always like to blog about something I don’t see very often, and topics that make people think. So I was doubly excited to get this idea after having our tools examined by many analysts/traders/risk managers/PMs last Thursday and Friday, in New York. (We just completed our launch of MetaSwing for Bloomberg Professional on Monday, November 7th 2011. This is our suite of volatility-based quantitative technical analysis solutions. And, you can get a free 30-day demo by typing APPS CS:MS ).

Usually the first thing that happens is the analyst/trader picks the most obscure security (read – something that tends to “break” the technicals). And, that’s exactly what happened! They started pulling up, of all things, price charts of options contracts. Options on futures, indices, VIX charts, etc… Surprise, it worked! This is due to extensively and correctly testing our tools, but also because of what the tools are based on: volatility. Volatility is the key to getting something to be truly adaptive to a time frame or market. However, there are a lot of great talking points here to explore!

Many have told me that there is nothing that you can discern from these types of charts, including seasoned options traders. If all you had to work with was the typical set of indicators, I’d probably agree with that. However, our work is volatility-based and hence, it fits very well into dissecting a derivative’s traded history for actionable info.

Whenever possible, I always trade off of the chart that I am trading vs. some sort of proxy. This seems so logical but often we are forced to do our analysis on some benchmark or highly correlated security. An example would be using the VIX vs. looking at the actual implied chart for the security itself. I’ve written about this recently here.

So, why not look directly at the option’s pricing history instead of or along with the underlying? It may seem like a strange question, but to me it’s absurd to not consider it. I also find this interesting because many times I hear options traders speak of how easy it should be to hit (insert ridiculous number here) % return on an option trade. Well, how about knowing a level that the actual option itself was probabilistically going to encounter a headwind/resistance? As a trader, I’d say that is one useful piece of intel.

This is the 11/19/11 expiration 170, and calls for GLD, SPDR Gold Trust ETF (left) with the stock chart (right). I have highlighted two examples: 1) is a with-trend trade while 2) is counter-trend.

From a setup point of view, the stock chart (right) and the options chart (left) are identical: a) trend outlook is positive (or negative for 2), b) momentum is at an extreme, c) a directional signal(s) identifies a favorable condition, and d) this is right against volatility-based support. The major difference is that I have a clear idea of what my profit potential is, vis a vis objective and predictive resistance. My risk to reward is clear given the levels (using the options chart, example 1 is 3:1 and example 2 is 6:1). Green arrows are drawn to demonstrate a first level of resistance-based targets.

This approach has many benefits. For one, I can eliminate low reward or high risk trades. Additionally, I can gain a greater level of precision in both entering my trade and managing the risk of the trade. Finally, I can get an idea of the bang for my buck that the leverage a particular contract is garnering. All of this could easily complement an existing framework of trade considerations.

Carson Dahlberg is the Chief Technical Strategist and Partner at Northington Trading, LLC.