analysis limits & options

Atlanta Options InvestorsAtlanta Options Investors

Using Options to OvercomeUsing Options to Overcome

thethe

Limits of Technical AnalysisLimits of Technical Analysis©©

byby

Eric HartfordEric Hartford

23 February 200923 February 2009

Disclaimer – The markets are an expensive place to learn. Don’t even think about trading with money that you cannot afford to lose; in fact, kiss off your entire trading account before your first trade- it’s gone! What were you thinking? All trading systems involve losses. Past performance means nothing. Don’t believe anything you can’t prove. Eric Hartford is not a registered security representative nor financial advisor, bears no responsibility for you or your actions, has obvious trust issues, and laughs at; efficient market theory, bipartisan commissions, soft landings, mutual funds, dollar cost averaging, self-regulation, the SEC, buy and hold, corporate integrity, BLS statistics, CPI calculation, petroleum reserve estimates, re-stated earnings, & the Laffer Curve. Of course, the market is rigged against you, but you can’t win if you don’t try.

Creative Destruction Company

© 2009 All Rights Reserved

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ContentsContents

•• Technical Analysis Technical Analysis

•• Bias and LogicBias and Logic

•• Evidence & Probabilities Evidence & Probabilities --

candlestickscandlesticks

–– Swope, Aronson, Swope, Aronson, TalebTaleb, ,

BulkowskiBulkowski

•• Option Trade Strategies as Option Trade Strategies as

candidates forcandidates for

•• System DevelopmentSystem Development

–– and all in half an hour… or and all in half an hour… or so….so….



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Candlestick PatternsCandlestick Patterns

•• AssumptionsAssumptions

–– Graphically Graphically

represent represent

market market

psychologypsychology

–– All information All information

reflected in reflected in

high, low, high, low,

open & close open & close

priceprice

–– Within the bar Within the bar

activity activity

unimportantunimportant



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Candlesticks Candlesticks --

IndecisionIndecision

•• Dojis, stars, spinning tops indicate Dojis, stars, spinning tops indicate

indecisionindecision

•• Indecision often precedes a change of Indecision often precedes a change of

sentimentsentiment

•• Dojis can form at Pivot Pts, Support, Dojis can form at Pivot Pts, Support,

ResistanceResistance



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Candlesticks Candlesticks –– Support & Support &

ResistanceResistance

•• Long shadows indicate reversal, shadow > Long shadows indicate reversal, shadow >

2x body2x body

•• Shooting star at tops, Hammer at bottomsShooting star at tops, Hammer at bottoms

•• Buy at support in upBuy at support in up--trends, Sell at trends, Sell at

resistance in downresistance in down--trendstrends

•• GETTING IT BACKWARDS IS A HUGE GETTING IT BACKWARDS IS A HUGE

MISTAKE !!!MISTAKE !!!



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Long legged ReversalsLong legged Reversals

•• DowntrendsDowntrends–– Lower closing Lower closing

lowslows

•• UptrendsUptrends–– Higher closing Higher closing

highshighs

There There must be a must be a

trendtrend to reverse or to reverse or

confirm, confirm,

according to Greg according to Greg

MorrisMorris



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Nonsense !Nonsense !

Subjective or Objective TA Subjective or Objective TA

??

•• Subjective Technical Analysis is loreSubjective Technical Analysis is lore

–– Contains no/few programmable Contains no/few programmable assertionsassertions

–– “Received Wisdom” “Received Wisdom”

–– Many charlatans Many charlatans -- time AND price time AND price predicted?predicted?

•• Evidence Based Technical Analysis Evidence Based Technical Analysis

–– Objective, Tested, RepeatableObjective, Tested, Repeatable

–– Based on Scientific Method, Based on Scientific Method, Probability, MathProbability, Math

–– DataData→→ FactsFacts→→ KnowledgeKnowledge→→Profitable SystemProfitable System



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Common BiasesCommon Biases

•• Optimism or Optimism or Overconfidence Overconfidence BiasBias

•• HindsightHindsight biasbias-- “post hoc ergo “post hoc ergo propterpropter

hoc”hoc”

•• ConfirmationConfirmation bias bias –– evidence disregardedevidence disregarded

•• Illusory Illusory CorrelationCorrelation -- cause or just cause or just

correlation?correlation?

•• RepresentativeRepresentative bias bias -- “Fooled by “Fooled by

Randomness”Randomness”

-- Sample size neglect, data miningSample size neglect, data mining

-- Tendency to see patterns where none Tendency to see patterns where none

existexist

•• NarrativeNarrative bias and conjunctive fallacy, 2bias and conjunctive fallacy, 2ndnd

handhand

•• AvailabilityAvailability bias bias –– Anchoring, Gamblers’ Anchoring, Gamblers’

FallacyFallacy



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RisksRisks

•• Kurtosis Risk Kurtosis Risk –– “Fat Tails”“Fat Tails”–– All math models break down All math models break down -- Normal, log Normal, log distsdists, Sharpe… , Sharpe…

–– Is faith in a flawed model, better than no Is faith in a flawed model, better than no faith? Ask LTCM…faith? Ask LTCM…

•• Expectancy RiskExpectancy Risk–– confusing winning percentage w/ confusing winning percentage w/ expectancyexpectancy

•• Black Swan logical fallacyBlack Swan logical fallacy

•• Option position graphs Option position graphs –– Necessary Necessary but never Truebut never True

•• Not recognizing volatility and time risks Not recognizing volatility and time risks ––““reckonizingreckonizing””

•• Trading without a systemTrading without a system

•• System not compared to indexed System not compared to indexed returnsreturns–– Based on incomplete, incorrect dataBased on incomplete, incorrect data



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““Technical Analysis”Technical Analysis”

All Statements

Commands

Empty Claims

QuestionsGraphic from

Evidence Based TechnicalAnalysis

by D. Aronson, Wiley & Sons©2007

Well-formed Declarations

True Statements

True Beliefs

Justified by

Evidence

Beliefs &



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TA TA -- Subjective or Subjective or

Objective ?Objective ?

•• TechicalTechical

Analysis is a Analysis is a

slippery slopeslippery slope

•• PseudoPseudo--science science

is worse than is worse than

wrongwrong

–– no basisno basis

–– all biasall bias

•• Likely to leave Likely to leave

you hanging…you hanging…



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TA TA -- Subjective or Subjective or

Objective ?Objective ?

•• TechicalTechical

Analysis is a Analysis is a

slippery slopeslippery slope

•• PsuedoPsuedo--science science

is worse than is worse than

wrongwrong

–– no basisno basis

–– all biasall bias

•• Likely to leave Likely to leave

you hanging…you hanging…



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Evidence Based Technical Evidence Based Technical

AnalysisAnalysis

•• Trends exist in sectors, commodities Trends exist in sectors, commodities & currencies which can be exploited& currencies which can be exploited

•• High Relative Strength equities High Relative Strength equities outperformoutperform

•• Simple rules can yield significant Simple rules can yield significant profits applied to indexes of young profits applied to indexes of young companiescompanies

•• Neural networks can generate rules Neural networks can generate rules that yield profits in excess of indexesthat yield profits in excess of indexes

•• Volume contains predictive Volume contains predictive informationinformation



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If you insist on owning If you insist on owning

equities… equities…

Costless Collar Payoff Diagram



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Low Risk High Reward Low Risk High Reward

TradesTrades

Long Strangle Payoff Diagram



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Limited Duration Limited Duration ––

““lowishlowish” risk ” risk

Put Backspread Payoff

Diagram

Butterfly Spread Payoff

Diagram



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BlowBlow--off Tops, Waterfall off Tops, Waterfall

SellSell--offsoffs

•• Extreme Relative Strength Extreme Relative Strength

Index ReadingIndex Reading

•• Volatility Skewed in both time Volatility Skewed in both time

and strikesand strikes

•• Diagonal calendar spreads Diagonal calendar spreads

??????

•• and now a digression on and now a digression on candlesticks…candlesticks…



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Tom Tom Bulkowski’sBulkowski’s

thepatternsite.comthepatternsite.com

•• Courtesy of Courtesy of thepatternsite.comthepatternsite.com

•• Statistics on 4.7 million daily US Statistics on 4.7 million daily US Equity candles Equity candles

•• 103 daily candle patterns ranked 103 daily candle patterns ranked –– % of the time accurate% of the time accurate

–– Frequency rankFrequency rank

–– Performance rank 1, 3, 5 & 10 days outPerformance rank 1, 3, 5 & 10 days out

•• Top ContinuationsTop Continuations

•• Top ReversalsTop Reversals

•• Top PerformersTop Performers



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Bullish Reversal Bullish Reversal

StatisticsStatistics

Hammer:Morning DojiStar:

HammerBullish Reversal 60% timeFrequency: 36Performance: 65

Takuri /Down end dragonflyBullish Reversal 66% timeFrequency: 28Performance: 47

Morning Doji StarBullish Reversal 76% timeFrequency: 78 Performance:25

Morning StarBullish Reversal 78% timeFrequency: 66Performance: 12



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Bearish Reversal Bearish Reversal

StatisticsStatistics

Evening StarBearish Reversal 72% timeFrequency: 71Performance: 4

Evening Doji StarBearish Reversal 71% timeFrequency: 81Performance: 30

MUST NOT GAP – OTHERWISE CONTINUESShooting StarBearish Reversa 59% timeFrequency: 37Performance: 55



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Top Candlestick Myths Top Candlestick Myths

BustedBusted

Inverted HammerTheory: Bullish ReversalFact : Bearish Continuation 65% timeFrequency: 61Performance: 6 OUCH!

Hanging ManTheory: Bearish ReversalFact : Bullish Continuation 59% timeFrequency: 16Performance: 87

Gap Shooting StarTheory: Bearish ReversalFact : Bullish Continuation 61% timeFrequency: 51Performance: 52



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Candlestick StatisticsCandlestick Statistics

77%40%36

%70%40%

30

%S&P 500

91%35%57

%88%36%

53

%Bonds

65%39%26

%62%35%

26

%MiniDow

TotalsShooting StarDojiTotalsHammerDoji

HighsLowsUnderlying

Courtesy of John Persons – National Futures



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ConclusionsConclusions

•• Develop system & trade it Develop system & trade it

•• Based on data!Based on data!

•• Exploit sector, commodity, FX trendsExploit sector, commodity, FX trends

–– low risk, far OTM strangles, butterflieslow risk, far OTM strangles, butterflies

•• Ratio spreads (Ratio spreads (backspreadsbackspreads) )

–– limited time of minimal risk limited time of minimal risk

•• Diagonal Calendar Ratios worth further Diagonal Calendar Ratios worth further

investigation to blowinvestigation to blow--off tops, waterfallsoff tops, waterfalls

•• Exploit skewsExploit skews

–– Time Time –– CalendarsCalendars

–– StrikesStrikes-- VerticalsVerticals

•• EBTA still an infant EBTA still an infant

•• REMAIN SKEPTICAL !!! REMAIN SKEPTICAL !!!



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Thanks !Thanks !

Additional Resources

- http://www. oio.com/education

-http://www.optiontradingpedia.com

analysis limits & options

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subjective technical

narrative bias

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