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Relative Strength and Weakness: How it Affects Option Trading

Posted by Pete Stolcers on November 18, 2009

Option Trading Question

How does relative strength and weakness affect option trades?

Option Trading Answer

As you search for stocks each day, you can reduce your market risk in options trading by compiling a list of stocks that are strong or weak relative to the market. If you are successful at identify these stock traits you will have a basket of long and short positions to start your option trading.

Relative strength is generated by comparing the relative price performance of any two items (such as two stocks or a stock and a market index). If the first item in your comparison is out-performing the second item, the relative strength line will be rising.

Picture yourself sitting at your monitor and being horrified when you see that the market was tanking and you had a stock where you were long. Your worst fears are calmed as you check the quote on your stock and realize it has not participated in the sell-off, it actually has relative strength. Also imagine combining it with a short position on a weak stock, as you read the quote and smile as it dives.

This strategy explained is used extensively by hedge funds, with the goal of making 12% a year no matter what the market does. Here are a few strategies to implement as an individual in your options trading:

1. Consider smaller less liquid stocks

2. Add your market opinion to the equation and weight your longs and shorts

3. Consider option trading on stocks that they consider too ill liquid by large financial institutions

4. Have the ability to adjust quickly while not impacting the stock price.

Market analysis is a key component of options marketing as you watch for sector rotation and weight your positions based upon your market opinion. In fact, you should begin and end your daily research with an analysis of the market. You will not have to compete with the largest financial institutions with the use of this strategy in one of the most liquid markets in the world. That’s very important in option marketing, so make sure you implement the strategy where possible.

Option Trading Comments

  • On 09/23, steve maynard said:

    Pete:

    It was interesting to read your comment in the magazine article about “scared money”.  That’s exactly where I am with my limited capital $5,000.  For example, I bought a DIA put for 4.30 and got “scared” and sold it at 5.15.  It is now over 11.00.  I have a good understanding of options and know I can make good.  I’m considering your Level 1 or 2 program.  Any suggestions considering my small capital?  Thanks Steve.

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