OVI At Work – Stock Selection with Simple Indicator

By on August 24, 2011

As humans, we have a habit of making investing much more complicated than it needs to be, especially in volatile markets.  Only three things can happen to any stock, it can move up, down or sideways.

Tools are great, but use ones that make your life easier, not harder!

Use the powerful tools and discipline at your disposal to take profits with amazing simplicity, especially under the current conditions of uncertainty.

Sophisticated Algorithms yet an Incredibly Simple Approach

One indicator gives insight into the inner dynamics at work in the market.  In fact it often precedes the price action as a leading indicator.  The OVI, (Options Volatility Indicator), tells the buying or selling story of a stock by measuring the dollar action of the most “In the Know” traders in the options markets.  However, the great thing about the OVI is that you don’t need to know anything about options to interpret it!
The OVI is derived from a pretty complex set of data and algorithms.  But by the time we use it, it’s just a simple line that travels up and down.

The Tough Autumn I Predicted Arrived Early

I’ve been saying for some time that the OVI has been relentlessly negative, we’re in for a tough autumn, and that this year has resembled 2008 in many ways.

Looks like these were pretty accurate assessments and the markets seem set for more wild gyrations.  So hang on to your hats … we’re in for a memorable ride – even if it’s for all the wrong reasons.

No matter how difficult things may be though, these times are fantastic learning opportunities while taking on no risk.  Observe and look at the tools you can already have at your disposal.  The OVI has been phenomenal in setting the scene.  It has been completely unambiguous in telling us which way the market is going, and as such, the more adventurous traders have made phenomenal gains – albeit accompanied by a bumpy ride.

SPY
Look at the chart below and you can see it’s pretty clear, isn’t it!  Wide ranging bars, big whipsaws, increasing volatility … this is a bearish market – not a bullish one.  You could get lucky by going long on a particular day, but you could lose your shirt the next day.  Stick to my rules of trading clean-looking breakouts, and you’ll be safe even during these wild times.

The OVI Indicator Revisited

As I’ve mentioned before, the OVI measures options transaction data and plots it as a simple line that oscillates between 1 and -1.  It is a key part of my trading plan each and every time.

When the line is positive, we’d be more inclined to focus on bullish chart patterns; and when it’s negative we’d focus the more bearish chart patterns.

We only use the OVI in combination with a chart pattern such as a consolidation or flag.  We never use it in isolation.

Although the OVI has nothing to do with the stock price, the correlation is often astounding as you will see over and over again – just look at the above chart for starters!

In many cases, the OVI will actually precede a breakout, and this is the key to our strategy.  We’re not looking to pick out highs and lows, just breakouts from clear areas of support and resistance.

In this way the OVI performs as a LEADING indicator because it so often precedes a breakout.

Used correctly together with our preferred chart patterns, the OVI demonstrates that the options markets can often be ahead of the stock market and is an invaluable tool.

Chart Pattern Positioning

Take a look at the simplicity of a short play in AMZN last week.  The first pattern has an ominous looking Bear Flag which had support at the $190 area.  The OVI has been sharply negative for the past two weeks alerting us that there was potential weakness with the stock.  A jump in volatility also adds another indicator in favor of this downside breakout.

As the stock broke through $190, a quick two-day drop of more than $10 per share was there for the taking by watching just a pattern and the OVI.  A further consolidation, followed by a break below the June $180 lows, could bring even more gains.

The play above is typical of trading breakouts with the OVI.

A current scan of stocks forming bear flag patterns is showing some great potential setups as we speak.  Potential just means it hasn’t happened … YET

JP Morgan Chase Example

1) Pattern – Bear Flag has yet to take out support below $34 area to confirm.

2) OVI – Negative reading for many weeks provides bearish insight.

Those two simple keys are all we need to simplify ALL of the confusing news and data in market to select trading candidates.  A JPM breakdown through the $34 level gets us short with an initial buy stop loss either at the top of the flag at $38, or tighter at $35.

One of the best advantages of the “Pattern First” approach is when we are wrong.  A failure to break through the flag support doesn’t lead to any position in that stock.  And “No-Trade” means No Losses!  We are never in until the price breaks out.  Now we just wait to see if the market drops to trigger the JPM short entry.

Use the tools at hand to build the trading plan – it really is so simple.

This simple approach makes use of a sophisticated tool that legally puts you on the same side as the professional (and inside) traders.  And it also uses one of the best trading strategies ever devised – trading breakouts from support and resistance.

 

 

 

 

 

About Guy Cohen

A true innovator, Guy Cohen is the creator and originator of Flag-Trader, The OVI Index, and OptionEasy. He is also the author of the best-selling trading books "Options Made Easy"...Read Full Bio »

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