This is the option trader’s best technical weapon

I am a “tactical options trader”, meaning that I usually look for market signals first (up, down, sideways) and then I “fit” an options strategy to that signal or market view, depending on current market conditions (volatility levels, skew, term structure, etc).

Options’ trading is all about movement. “How” an underlying moves is every bit as important as “where” it moves. Failure to incorporate this factor into an options strategy can lead to very disappointing outcomes.

We’ve all been there – you get a buy signal on a stock or index, you step in and buy some calls, and then as the stock or index rallies, implied volatility gets smoked and you end up with a few crumbs of profit. Being wrong and losing money is one thing - that is part of the business, but being right and losing money makes you want to put your fist through a concrete wall (this doesn’t work, by the way).

For my money, Market Profile™ is the best technical tool in my toolbox. Developed by the legendary J. Peter Steidlmayer with the Chicago Board of Trade, Market Profile™ provides a graphical description of price distributions over time, and to an options trader, distributions are everything.

I am not looking to conduct a Market Profile™ lesson in this article, but in a nutshell, the prices at which an underlying trades for various time frames are recorded with a letter representing that time frame (a Time-Price Opportunity or “TPO” in profile lingo). As the trade builds throughout the day, week, month or whatever time frame the user chooses to examine, distributions develop, and these can be incorporated into option strategies.

Google (GOOG | Quote | Chart | News | PowerRating) – Daily Profiles

Above is an example of a daily profile of Google (GOOG | Quote | Chart | News | PowerRating). Each day is broken into 30-minute segments, and each 30-minute segment assigned a letter. As the day develops, the trader can see what the distribution looks like, and where a stock “likes to go” (good places to locate the short options component of a strategy) and where a stock “does not like to go” (good places to locate the long options component of a strategy).

These time frames can be altered by the user to get a longer- term view of distributions. This is extremely helpful for constructing options strategies. Below is a profile of the SPX over a monthly time frame. A letter represents each day of the month and the user can see “how” the SPX moved as well as “where” it moved:

SPX (SPX | Quote | Chart | News | PowerRating) – Monthly Profiles

July was clearly an upwardly distributing month early, but the market found “value” in the latter part of the month, roughly between 1210 and 1240 (blue line to the right of the July profile). The SPX has continued to explore this range during August. The savvy options trader could have constructed long butterfly or other short volatility strategies around this area.

I would urge every option trader to get acquainted with Market Profile™ and how to interpret it. You can go right to the horse’s mouth at ProfileTrading.com or the CBOT also has an abundance of information, including a list of vendors who offer market profile.

Bon Appetit!

Joe Corona is a 23-year veteran trader who makes his living trading options and other derivatives. Mr. Corona has been a floor trader on numerous exchanges including the CBOE, CBOT, and CME. Joe most recently spent 4 years as Head Trader for Market Wizard Tony Saliba at Salibaco, a proprietary trading firm. He has also been an options instructor for the International Trading Institute where he has trained hundreds of options and derivative traders for major institutional trading desks worldwide. Joe is the Director of the Asia Pacific region for CDLS Consulting, LLC which specializes in trading U.S., European, and Asian options and derivatives.