Chart analysis for binary options trading
The nuts and bolts of binary options trading are relatively straightforward. To make a long-term profit and avoid heavy losses however, you need to develop a solid trading plan and get your analysis right.
In this lesson we will focus on how technical analysis and the use of price charts can help you determine which asset to trade, which direction prices will move, what time frame will work best for you and at which levels you should enter trades. We will also introduce some of the main technical indicators that binary options traders find useful.
The importance of charts in binary options trading
Technical analysis involves the study of charts to identify historic patterns in a price that tend to repeat themselves under similar conditions. It is considered the most reliable form of analysis for binary options traders and will help you form a view on how prices are likely to behave in the short and long term.
Charts can be an excellent resource in binary options trading but it is important that you don’t over-rely on them, especially when you’re still learning. Too many novice traders plunge straight into the world of technical analysis, over confident in their abilities before they have even mastered the basics. Eye-watering losses can result.
Make sure therefore that you invest time in studying the various forms of technical analysis, familiarising yourself with different patterns and indicators one by one before you move onto the next.
Some indicators are more reliable with certain assets or time frames and you’ll only get a feel for which works for you with practice. So open a demo account with your broker and use it for at least a couple of months to experiment with different charts and indicators before you start placing ‘real money’ trades.
Even once you are more experienced, a demo account is a great way of fine-tuning your strategies and trying out new ones - at no risk.
Technical analysis: the basics
Most technical analysis relies on the historical observation that asset prices have a tendency to hit areas of support or resistance through which they struggle to fall or rise, respectively. If these barriers are broken, price movements in the direction of the breach often gain momentum.
There are two main approaches to technical analysis that can help you identify support and resistance levels and predict how prices will respond to them: patterns and technical indicators. Some binary options traders favour one over the other. Many use a combination of both.
Traders who focus on technical indicators rely on indicators such as MACD, ADX and stochastics to alert them to trading opportunities.
Traders who focus on patterns try to identify specific shapes such as so-called ‘double top’ and ‘head and shoulders’ patterns as they form on their price charts.
One of the key challenges with this analysis style is that real-life chart patterns are rarely as picture perfect as the textbook examples. Traders therefore have to make a decision on whether what they see on their chart is a bonafide trading signal or not. As prices are constantly in motion, they also have to learn to anticipate a pattern forming before it completes, and to act on it fast.
Whichever approach you decide works for you, be careful not to over-complicate your analysis by focusing on too many indicators or patterns at once. A cluttered chart is hard to read and less reliable.
How to choose an asset to trade
Choosing the right asset or assets to trade with binary options can be key to your success.
It is possible to trade binaries on a wide range of underlying assets, from stocks and indices to commodities and foreign exchange, so make sure you choose a broker that offers you plenty of flexibility.
Different assets behave differently, and some work better with certain indicators, price patterns or time frames than others. Foreign exchange markets, for example, tend to move fast. A binary options trader focusing on the USD-GBP currency pair will therefore probably want to use charts with shorter time frames than might a trader of an industry index.
Be careful that you don’t try and trade too many assets at once – it’s far better to familiarise yourself with one or two and master your approach to them.
How to identify a trend or trend reversal
Because binary options trading at its heart involves betting on whether an asset price will rise or fall, identifying price trends and recognising when they may be about to run out of steam or change direction is one of the most important skills you must develop.
For traders that rely on technical indicators, one signal that an upward trend could be about to switch direction and reverse to the downside is when moving averages display a downward cross. When moving averages show an upward cross, this can signal that a downward trend will change to an upward move.
Another way that binary options traders can form a view on whether an existing trend is going to continue or reverse is by looking out for the so-called 1-2-3 setup.
This setup forms when the price of an asset continues moving higher or lower in the direction of an existing trend but then stops and pulls back slightly before continuing the trend.
One way of identifying the 1-2-3 setup is by monitoring Fibonacci levels to see if the price pullback is greater than 38.2% of the previous move. If it isn’t, most binary options traders conclude that the trend will soon continue and use the pullback as an attractive entry point for a new binary trade in the direction of the original trend.
If the 1-2-3 pattern fails to complete and price pullbacks are greater than 38.2% of the previous move, binary options traders often conclude that the trend is reversing. A double-bottom shape resembling the letter ‘W’ will sometimes form on the chart before the reversal gets underway.
Some binary options traders meanwhile use a combination of the Fibonacci retracement tool provided by most charting software and the stochastic oscillator.
The Fibonacci retracement tool helps traders identify when a price correction or retracement in the midst of a wider trend is about to end and the initial trend continue. As with the 1-2-3 setup, it allows traders to buy binary options traders at around the point the trend restarts.
To ensure a high probability trade, many will also wait for the stochastic oscillator – a technical indicator that identifies when a price has become ‘overbought’ (over 70 on the indicator index) or ‘oversold’ (below 30 on the indicator index) – to tell them a reversal is likely.
How to choose a time frame and expiry time
Price charts are broken into small bites known as time frames. These typically last for 1, 5, 15, 30, 45, 60 or 90 minutes, or for a whole day, week or month.
Most binary options traders start off using daily or weekly charts, and then graduate towards shorter time frames as they gain experience and if this suits their trading style and favoured underlying assets. Even for very short-term traders, however, it is sensible to check longer-dated charts at least daily, if only to keep abreast of slow-moving trends and form a view on how they might affect short-term price action.
Because binary options expire worthless if a certain scenario is not achieved within a specified time frame, they are extremely time sensitive. This means it is crucial to pick the right time frame and expiry so that trends have enough room to run.
If, for example, you correctly identify a downward trend and buy a put option, you could find your option expires out of the money if a retracement or correction to that trend occurs just before the contract runs out. In this scenario, you should have chosen an option with a longer time frame to allow the retracement to end and the trend to resume.
One way traders can allow themselves more room in such a scenario is by purchasing a roll over from their broker, if they offer this tool. A roll over allows you to extend the expiry time of your option if a price correction occurs and you think it will be short-lived.
One popular rule of thumb among binary options traders choosing expiry times is to go for one that is at least three times as long as the time frame of the strategy you have chosen. If, for example, the strategy you are following uses a five-minute chart, choose an expiry time of at least 15 minutes.
Also, try and gauge market volatility and momentum. If prices start to move very quickly after you received your trading signal, go for a shorter expiry time. If moves take a while to get going, opt for a longer expiry time.
Similarly, if market conditions are very volatile or choppy, use a shorter expiry time than you would in slow, ranging markets or periods of fairly smooth price action.
So far you have learned that:
- by analysing historic price movements on the charts you can draw conclusions about its future direction
- binary options traders use support & resistance, price patterns and indicators to predict price movements
- a good way to choose an asset is by checking how fast or slow it tends to move
- Binary option traders typically use moving average crossovers, the so called ‘1-2-3 pattern’ or Fibonacci retracements to determine market direction
- combining two or more tools such as Fibonacci retracements and stochastics can give you powerful trading signals
- binary option traders generally go for an expiry time that is at least 3 times longer than the time frame they take their signals from