Yesterday, I sent you my comprehensive guide to the basics of options trading, which gives you the foundation you need to trade options.

But today, I want to focus on something we covered in Part 2: Predicting ANY Stock’s Next Move.

Now, at some point in your life, I’m sure you’ve heard the following “conventional wisdom” from the financial pundits on TV, your spouse, a friend – heck even your broker:

You can’t predict the stock market.

And yes… you can’t predict how the markets will behave with absolute certainty. There’s no Magic 8 Ball out there that will tell you exactly what’s going to happen next in the stock market.

But with the right tools, you can determine where a stock or exchange-traded fund (ETF) could move tomorrow, next week, next month, and beyond.

And it all boils down to these three little charts…

The 3 Charts Every Trader Should Know & Exactly How to Read Them

I think it can go without saying that stock charts are extremely popular. Stockcharts.com, for example, has over 1.9 million active monthly users worldwide and is still growing.

But are stock charts really required to be a successful trader — or are they just a waste of your time and money?

Here’s the truth…

You can chuck most of it in the garbage.

Sure, there are some charts out there that certainly look fancy, but trust me, they don’t actually provide any useful information you need to set up trades.

That said, there are a few that are absolutely crucial to correctly timing your entries and exits. 

Here are the only three charts you really need…

1. Open, High, Low, Close (OHLC)

This tracks a stock’s or ETF’s open, high, low, and closing price of each trading day. This is the most important type of chart that exists because it reveals the patterns that identify trends, such as reversals and inversions. In fact, every other chart out there comes from this one:

What you’re looking at above is an example of an OHLC chart that I pulled using my proprietary tools. The bars can represent different time increments (one minute, one month, one year, etc.); however, the standard time frame for this type of chart is one day. Regardless of the time increment the bar reflects, each bar will represent the open, high, low, and closing price of that time frame.

The high is marked by the extreme top part of the vertical bar. The low is marked by the extreme low of the vertical bar. A small horizontal line connected to the left part of the vertical bar represents the opening price. A small horizontal lined connected to the right part of the vertical bar represents the closing price:

Here’s an example of a bullish and bearish chart:

2. Candlestick

This chart not only tracks a stock’s or ETF’s opening, high, low, and closing prices – it also shows the range between the opening and closing prices as well as the highs and lows of the day. This is my favorite type of chart because it gives you an even better picture of trends that are forming or reversing in the markets.

At the top of the next page is an example of a candlestick chart that I pulled using my proprietary tools.

The distance between the opening and closing price is called the candle’s “real body.” The wick is the high above and the low below the opening and closing prices. If the opening price is higher than the closing price, then the real body of the candle is drawn in red or black. On the other hand, if the closing price is higher, as we like to see in an up trending (bullish) market, then the real body is usually clear or white. Keep in mind that these colors can vary from chart to chart.

You’ll also see that, in addition to the real body, most candles have upper and lower shadows, which are drawn in as a single thin line from the top or bottom of the candle. These lines reflect a stock’s or ETF’s highs and lows. The upper shadows reveal the highest price achieved during the trading period while the lower shadows reveal the lowest price achieved during the trading period:

The last hour of the trading day is the most important one because it gives you clear clues as to where a stock or ETF (and the overall market) is heading next.

Now that we’ve covered the two most common charts you’ll find, let’s look at our final, lesser-known “chart” of the day…

Using a Risk Graph to Determine a Trade’s Worth Ahead of Time

Risk graphs are a great way for you to see the theoretical value (or profit potential) an option has at different prices and different time intervals up until expiration based on the underlying stock price. 

You can just as easily consider risk graphs as profit graphs because these graphs show both your risk on an option and your profit potential. 

Let’s look at a risk graph on a long call…

Most risk graphs are shown in what’s called a “modern view.” This is when the graph shows the “Profit ($)” on the vertical axis and the “Stock Price” on the horizontal axis. 

As you can see above, this chart is a little different… 

Instead of using the modern view, the graph above shows the “Profit ($)” lying on the horizontal axis, and the “Stock Price” on the vertical axis.

That’s because this graph is from my own tools, and I can flip flop the axes. This allows me to look at the price of an option the same way I would when looking at a stock chart, which is a much better view in my opinion.

But whichever way it looks, the information should be the same…

Here are the five components of a risk graph that I’ve labeled above:

1. Stock Price

2. Profit ($) per one contract. This is not the option’s premium (the price you paid for the option).

If the graph shows, say, 200, then it means the value of the option has increased $200 – not the premium. 

For example, if the premium to open your position was $3.00 (or $300 since one contract equals 100 shares), it should now be $5.00 (or $500). This means that the profit – or value- of the position is $200 ($500-$300 = $200).

3. Each colored line to the left of the “0” vertical axis represents the loss (or depreciation) of the option’s premium up until its expiration. The black line represents the options’ expiration.

The maximum loss (100% of the option premium) is realized when the stock trades at that price or lower at expiration. 

4. Each colored line to the right of the “0” on along the “Profit ($)” axis represents the profit potential (or value of the option’s premium) at the specific time interval and price (these are also colored lines).

Long calls theoretically have unlimited upside value potential, as there’s no limite to how high the stock can climb. Just keep in mind that options do eventually expire, so this unlimited profit potential only lasts until market close on the day of expiration.

5. The red line represents the number of days the option has until expiration.

The blue and green lines reflect that one quarter of the time to the option’s expiration has elapsed. Remember, the black line represents its expiration day. 

The dark blue horizontal line is the breakeven line. It shows you the price and time intervals the stock needs to be at to break even. When you break even, it means that there’s no gain or loss on the trade.

The light blue line is where the stock needs to be at the breakeven point at expiration.

Now the risk graph reflects the risk and profit potential of the option strategy you choose to use.

Some strategies allow what’s called an unlimited reward potential (which is when the option can increase as far as the stock can go). Other strategies have limited risk – and limited reward- such as spread trades.

For now, we’re going to see exactly how risk graphs can reveal the destiny of a trade…

How Risk Graphs Help You “See Into the Future” of an Options Trade

Now that we’ve broken down each piece of the risk graph, let’s look at how it can tell you the future of your trades – and whether they can unleash an unlimited stream of cash for you. We’ll focus on long calls today given the seasonal bullishness ahead of us…

When you buy long calls, your maximum risk is simply the price you paid for the option times the number of contracts you bought. 

Now you may be used to hearing the term “limited risk” when you think of long calls, but just keep in mind that your maximum risk is the total cost of the trade… so you can still lose 100% of the money you spent on the trade. The reason it’s deemed limited is simply that it costs you less money to buy an option on a stock than to buy the stock itself. 

Take the Microsoft Corporation (MSFT) October 11, 2024, $415 Calls below, for example. Keep in mind that this is strictly for education purposes and is NOT a trade recommendation:

If the option’s premium (the cost of the option) is $3.50, then your maximum risk potential is $350. Remember that one contract is equal to 100 shares, so you take the premium of $3.30 and multiply it by 100 shares to give you the maximum risk potential of $350. 

The maximum risk is realized when the stock trades at $415 or below. 

Here’s how that risk is graphed out…

That’s all for today, but stay tuned…

Tomorrow, I’m going to show you how I decode the financial markets – in just five easy steps.

Talk soon,

Tom Gentile
America’s Pattern Trader