Almost all options traders have heard an ancient trading saying that says, “Trend is your friend.” Indeed, options trading toward a prevailing market trend definitely puts the odds of winning in your favor. Too many novice options traders have lost entire accounts by buying call options in a bearish trend market and buying put options in a bullish trend market.
So what is the market trend?
Market trends are similar to ocean tides. You know it’s a tide when you see the sea rising higher and higher on the beach and you know it’s a tide when you see more and more beach. Similarly, you know it’s a bullish trend when you see major indexes like the Dow Jones industrial average or the S & P500 that goes higher and higher, and you know it’s a bearish trend when you see that major the indices go lower and lower.
Yes, market trends are general directions in which stocks seem to be moving. In the bullish trend most stock prices will move higher and higher, and in the bearish trend most stocks will move lower and lower.
However, one thing to understand in trends is that trends are the “general direction of movement”. This is not to say that in a bullish trend the market is only moving up every day and it does not mean that in a bearish trend the market is only moving down.
If you observe ocean tides, the rising sea does not continue to rush to the beach, and comes “Waves”. One wave higher than the previous one. This is the same in stock market trends. In the bullish trend you will see days moving with days down. However, the days of recovery will occur more frequently and will reach new highs after each minor retreat.
This fact often comes as a surprise to new traders who interpret the first day of the fall in the bullish trend as a “bear” market. This is also how beginners and veterans options traders are presented with the sayings “Bull Trap” and “Bear Trap”, which are short counter-trend moves that are misinterpreted as a trend reversal. Traders who fall into any trap are usually surprised when the general trend resumes and they fall into a losing position that never unfolds.
Recognizing how trends really work is only the first step toward recognizing market trends. Have you ever come to the conclusion that the market is going in one direction, only to have peers disagree with it? How can two people looking at the same market come to different conclusions regarding a market trend?
The difficulty of recognizing market trends comes with the understanding that the market can really be in all three directions on the same day at any time!
The market may be in a bearish trend for day traders, but on the same day it may be in a bullish trend for the swing trader and a neutral trend for the long-term investor. How is this possible?
In fact, there is not just one “Market” condition, but countless market conditions depending on the time frame on which it is traded! Failure to recognize that a market trend is different for different trading horizons and investment purposes has led to a meaningless argument about what the market trend is.
If you have charting software, you may be shocked to see that often you will see a completely different sample chart on the same index or stock, depending on what timelines you are looking at; A 1-minute schedule, a daily schedule, a weekly schedule, or a monthly schedule seems to tell you all about the other.
A schedule that looks extremely bearish on a 1-minute schedule can look extremely healthy and bullish on a daily schedule. Thus, trend analysis requires first and foremost an understanding of the exact time frame on which you are trading.
Recognition of the exact time frame on which you trade is an extremely important condition in options trading, where the contracts and positions you have bought are time sensitive! Yes, option positions don’t last forever, and all option strategies have the perfect amount of time during which you can optimize profits.
For example, if you trade options for the day and write or buy options to close them to make a profit by the end of the trading day, the market trend you need to engage in will be the intraday trend most often identified from the minute chart. In this case, whether the market is a long-term bullish or bearish trend, it no longer affects your trade. The world may be screaming bullshit, but if your minute charts show a bear day, then a bear is the direction from which you make money.
If you are trading a closed call, you may want to write call options for a stock that is relatively sideways on daily charts if the market is trading within the range on daily charts if you are going to keep stocks from destination.
Conversely, when you buy long-term LEAPS options, you may be more concerned about what is a long-term market trend rather than worrying too much about daily volatility.
So what are the most commonly used tools for recognizing market trends?
Most veterans are able to recognize a trend that includes a chart just by looking at what the price chart looks like. However, for the less experienced or technically more inclined over the centuries, countless complex technical indicators have been invented. Personally, the most time-tested is the simple moving average. Which just averages the price over a period of time to see where it normally moves. This is what I personally count on most of the time, and use a different period moving average for different time horizons. The most commonly used periods are 30 days or 50 days.