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Options Theory: This is What Capitulation Looks Like

November 16, 2018

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Capitulate: verb – to surrender unconditionally, to give up resistance

Contrarian traders seek signs of capitulation in a bear market. Specifically, evidence that bulls are throwing in the towel and abandoning their once beloved positions. Picture the pain getting so bad that beleaguered longs finally stick their grubby digits down their collective throats to puke up what was once a sumptuous purchase. Variations of the theme are summarized by such phrases as, “buy when there’s blood in the streets” or ” you want to be greedy when others are fearful.” I think this week’s crash in the oil pits provides a perfect example.

We’ll use the United States Oil Fund (USO) to illustrate.

Options Theory: This is What Capitulation Looks Like

Signs of Capitulation

Allow me to introduce the four signs that capitulation is nigh:

  1. Oversold market
  2. Ramping realized volatility
  3. Volume climax
  4. Implied volatility spike

1. Oversold Market

Selloffs worthy of the capitulation moniker don’t arise from mild conditions, nor do they spontaneously erupt in overbought markets. Instead, they strike when the victim is already down and bleeding, begging for werereprieve. We’re talking after a stock has already been beaten senseless driving the RSI and other such oscillators into the basement.

Does this not describe where crude oil sat on November 11th, the day before the crash? It had fallen eleven days in a row for the first time in decades reflecting an absolute absence of any buying appetite from participants whatsoever. At 20, the RSI was already perched at a two-and-a-half year low. The situation was ripe and indeed in need of capitulation to signal a tradable bounce was underway.

I believe Tuesday’s crash and the subsequent drop of the RSI to 14 was what we’ve been waiting for.

2. Ramping Realized Volatility

For true capitulation, you need urgency in the selling. And that doesn’t come via dojis and small-bodied candles. You need a ramp in actual market movement to signal emotions are running hot, and support zones are melting in the face of the fiery descent. The ramp in realized volatility can be seen in the Average True Range (ATR) indicator.

Note how the ATR was rising gradually during the descent, but finally spiked higher this week touching a two-year high at 37 cents. We’re seeing almost four times the daily volatility experienced last December.

Ramping realized volatility in oil land? Yes, sir.

3. Volume Climax

Panicked selling also manifests itself in the volume indicator. And how could it not? Does it qualify as panic if only a few nervous-nellies are abandoning ship? No. We need widespread liquidation otherwise it’s not severe enough to justify trading off of. Now, take a look at the volume during Tuesday’s plunge.

Total shares traded rocketed to over 83 million marking the highest single-day turnover since November 2016. A climax? I think so. It’s as if everyone who was holding out hope for the long-awaited oversold bounce in oil finally caved in, raised the white flag and surrendered their shares.

This increases the likelihood that a tradable bounce will commence, or at least that peak downside momentum has been reached for a spell.

4. Implied Volatility Spike

There’s a reason volatility measures like the VIX bear the nickname “fear gauge.” Skittish investors desire protection and are often willing to pay ridiculous prices for it. The groundswell in demand for put options drives implied volatility to the moon, thus tipping off spectators that peak panic has likely been achieved.

Did you see implied volatility this week? You can chart it for USO using either the indicator “ImpVolatility” or via the Index OVX. At 35%, the reading was already running hot, but on Tuesday it went into insane mode and jumped to 55%. If that’s not a spike worth printing out and sticking on the fridge for future reference, then I don’t know what is.

So What?

So what do we do when all these signs of capitulation crop up? Consider the following actions:

  • First, take profits on bear trades. If you’re a swing trader and don’t want to sit through a bounce in the stock then ringing the register for short trades is the way to go.
  • Second, avoid deploying new bear trades. Even though it appears as if the stock suffering capitulation will never rise again, your eyes are deceiving you. It’s always darkest before the dawn. Moreover, the risk-reward for new short trades at this point is terrible so avoid the temptation to chase.
  • Third, consider contrarian bullish trades like naked puts or bull puts to capitalize on the sky-high volatility and chance at a rebound in the stock price.

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