Look To The Left When Trading Options

Posted December 22nd, 2009 by Josip Causic in Trading & Analysis

Look To The Left When Trading Options
Often in my option classes I ask the students a question that only on the surface appears to be tricky: "What comes first, the price action on the chart or the print?" Most of the time, the students give me that puzzled look which tells me that most likely they are somewhat confused, yet as the discussion commences, the perplexity becomes more noticeable.

The majority of students have heard the expression that Price is King, yet when confronted with the above question, they feel that the dilemma is similar to "What comes first: The egg or the chicken?" Although I do not have a definitive answer to the egg-chicken question, I point out to my option students the following process of order flow.

Quotes, Not The Facts
The level two [L2] is where I start. At that level, which is invisible to many traders due to their selection of a broker, the quotes are posted for both buyers and sellers. Those quotes are just that: The quotes and NOT the facts. In Online Trading Academy's Professional Trader class, we teach that L2 displays the potential sellers as well as potential buyers.

Besides listing the potential sellers and buyers, the L2 also lists their order sizes as well as their names/I.D. The brokerages that offer L2 are commonly referred to as DAT (Direct Access Trading) platforms, for they are far and away superior to any other brokers that do not offer DAT. Just a quick side note, L1 or level one offers only the most basic information about the underlying such as current price, its open, high, and low as well as the volume up to that moment in time.

What L1 is not showing, who is potentially buying and who is selling as well as the bid and offer sizes, is actually shown in L2. Once again, I am emphasizing this concept of "potentiality" which is not factuality until the potentiality shows up on the print.

The Print
The print, often known under two additional names, Time and Sales, or simply as the Tape, is the factuality. The L2 is full of "want-to-be" buyers and sellers while the Tape lays out what has actually been done up to that second. Each print that appears on the Time and Sales is the handshake (transaction) between the buyer and the seller, or the contract pre-agreed upon, signed and consummated. There is no debate about its time of execution, most of the time, and its size. All is specified on the tape.

Once the print hits the Tape, it is only at that point that the mathematical numbers get plotted visually on the graph which contains both a horizontal as well as a vertical axis. The horizontal axis represents the time, while the vertical one stands for the price. Hence, to answer the original question: "What comes first, the price action on the chart or the print?" The answer is obviously ñ the print.

Had we not had the computer technology that we've got in the 21st century, then the price action which displays on the chart would not be as readily available to us as traders. Many of our Online Trading Academy students have not traded prior to attending our classes; therefore, they simply assume that the chart [Price is the King] comes before the Print.

Yet once the history behind the price action is explained to them in a simple and clear way, they do realize that the next step that they ought to do when they are trading is ñ look to the left at the representation of the prices in the past shown on the chart.

What is on the left, one might ask? The answer is simple: The previous turning points where the price action has found either its support or resistance. A trader trades the right side of the chart that is literally in uncharted territory while he or she utilizes the past price action to forecast the possible turning points. It is at those levels or zones that the imbalance of order exists between the buyers and sellers.

Feeling Bullish?
My whole point of explaining what comes first, the print then the visual graphing of the price on the chart, is to inform the reader that what happens on the trading floor of our exchanges must be fully comprehended. Many of the floor traders do not read the charts at all for it is the size of buy and sell orders that tell them where the turning points are. Those turning points have many different names: Support and resistance, and supply and demand are just some.

Anyhow, demand or supply is based on people's perception, so when the traders feel bullish, they send multiple buy orders which stack up on one side. Those feeling bearish are firing away their sell orders which are also received by the exchanges and stack up on the other side. As long as there are enough buy and sell orders, the market is moving smoothly; yet the moment the stack of buy or sell orders are out of balance, then a turning point takes place. The market can then violently move up or down.

By looking to the left, a trader can identify the previous levels at which the price action has encountered an imbalance of buy and sell orders. Once the trader identifies that, he or she has a higher probability trade at hand. An option trader could at that point place a spread trade with a directional bias.

In conclusion, this article has offered a deeper look into the history of price action and how it gets transcripted from the print into the actual chart which the traders use to base their decisions for entry and exits. It also pointed out that demand and supply are based on people's perception, so when the stack of buy or sell orders are out of balance, then a turning point takes place."