This is the first of a four-part series of articles describing an options trading system that accomplishes better than averages outcomes.

This first installment (Part 1) explains methods for selecting companies and quantifying technical attributes.

Coming installments explain:

Part 2: the theory and its assumptions, and the selection of strong reversal or continuation signals

Part 3: examples of applying the quantifying tests, with strong and weak outcomes

Part 4: the methodology and outcome of a two-year test

This theory was first documented in a paper written for and published by the Journal of Technical analysis (JOTA), which subjected the concept to a rigorous serious of peer reviews. The paper was published in the 2016 edition of JOTA, issue 69: JOTA issue 69 The theory was expanded and explained in greater detail in “Profiting from Technical Analysis and Candlestick Indicators” (FT Press).   Thomsett

During a two-year period, I executed 578 trades and achieved a 91.5% profitability, averaging 37.8% each year. This out-performed the DJIA by 2.8 times, where the yield averaged 13.5% over the same period.

How was this possible?

By applying a system of what I call signal correlation, I was able to execute a series of options trades. The theory underlying this might be called an Efficient Forecasting Hypothesis (EFH) which may be applied to redefine technical market efficiency. This idea is based on the belief that by developing exceptionally reliable signals and focusing on a short list of options trades, the better than average outcome is likely.

Most options traders classify themselves as swing traders, and this system is perfect for you if you define yourself in this way. The method involves two steps: selection of companies based on fundamental criteria, and then timing of trades based on technical attributes.

First, the fundamental test:

Fundamental criteria for stock selection

Description -1 points 1 point 2 points 3 points
Dividend yield 0-2% 3-4% 5%-up
Dividends per share .00-.10 .11-.39 .40-up
Dividends raised, last 10 years 0-3 4-8 9-10
Dividend payout ratio per year falling up 1 up 2-4 up 5+
P/E, highest last 10 years 40-up 31-40 26-30 25 or less
P/E, lowest last 10 years 31-up 25-30 20-24 under 20
Revenue per year falling up 1-3 up 4-8 up 5+
Earnings per year falling up 1-3 up 4-8 up 9+
Debt capitalization ratio rising level -9-10% -11%+

The range of possible outcomes is between 27 (9 criteria @ 3 points each) and -3 (one point each for the first three criteria less 6 points for the last 6). The purpose in performing a fundamental test is based on the observation that strong fundamentals translate to strong technical performance.

The technical tests follow:

Technical criteria for trade timing

Description 0 1 2
proximity:

at or through resistance or support

close to resistance or support

signal at mid-range

 

 

 

 

0

 

 

1

 

2

Signal strength:

weak

average

strong

 

0

 

 

1

 

 

 

2

Confirmation strength:

weak

average

strong

 

0

 

 

1

 

 

 

2

Multiple confirmation:

weak

strong

 

0

 

 

1

Preceding trend:

weak

average

strong

 

0

 

 

1

 

 

 

2

 

The range of outcomes is between 9 (2 points for 4 attributes and 1 point for multiple confirmation) and zero (column 1). By applying percentages to these outcomes, the process identifies a level of confidence, between 0% and 90%. This further acknowledges that traders should never expect to achieve 100% confidence in outcomes.

The quantified value of fundamental selection is the first strep’; however, greater importance is assumed to belong to the technical side in a swing trading program, for two reasons:

  1. Earnings surprises have to be given considerable weight, since these often lead to exaggerated price movement, followed by correction. As a result, earnings surprises are fundamental indicators with immediate technical impact. This serves as a core observation among swing traders.
  2. Swing trading based only on technical price patterns and reversal signals overlooks the impact of fundamental volatility, thus increasing risk exposure that may not show up in a purely technical system.

 

The next three installments of this series further explain the theory and demonstrates the outcome of the fundamental and technical criteria. This concept will be further demonstrated on stock charts, and will conclude with a summary of methods used and outcomes over the two-year test period.


Michael is now a contributor to the Options Money Maker community offering more education for our traders through his extensive writings on options trading, technical analysis and charting.  He is the most published options author in the United States and offers a wealth of knowledge and experience for anyone seeking to learn the Art of Trading.