Last week we identified 3 different market types and we characterized them by direction, size and volatility. These three metrics are extremely important when choosing the right trade to be in tune with the markets.
There is a very common problem amongst newer traders and that problem is that when they learn a new trading strategy they want to use it all the time because perhaps they believe it is the holy grail of trading or perhaps they just don’t have the experience or knowledge of other types of trades. I have seen this with a lot of rookies, they get enamored with credit spreads and then all they do is look for credit spreads. Now, make no mistake I love credit spreads as much as the next person but I also understand that there are a time and a set of market conditions that make this trade work better. Picture this, you have the third scenario/market condition where the range is huge and the volatility is through the roof, would a credit spread be the best choice for that scenario? Probably not, there is just too much meat on that bone to only take a small slice of it. There is a tonne of better strategies for that type of market condition. We will jump into those strategies as we come to that particular market type but for this week we will talk about the condition that the market tends to stay in most as this would be the most beneficial for all as we will have to deal with this conditions more often.
The most plentiful market condition that we will see is the sideways, medium range, low volatility environment. This neutral type market is characterized by a gyration between support and resistance zones and typically has smaller size candles than a trending type market. The volatility in this type of market is usually lower and this tends to affect what we can trade successfully. If you recognize this type of environment then you can go about choosing the best trades that fit these conditions. In this environment, we need to look at a couple of “greeks” to understand what can work in this environment and what will most likely not work or at least be less efficient from a profiting standpoint.
With this market condition, we have some challenges and they come in the form of VEGA and THETA. If you are unfamiliar with these two concepts of trading then I will go over a brief explanation and then I will explain why they are important when choosing a trading strategy. First, up is THETA. THETA is time decay, if you are an options trader then you know that an option is a contract that has an expiration or end to that particular contract. This end or expiration can be both good and bad. It can be good if you know how to sell time but bad if you are only able to buy time. When we sell options contracts then we want time to go by quickly because we benefit from THETA, however, if we are buying options contracts then THETA or time passing hurts our position. if this is your first exposure to the option contract then I suggest you head on over to Tackletrading.com and check out the Options 101 course. This course will explain this concept in great detail. Now, the question begs, why do I care about this THETA thing? Well, when you are new to trading you are most likely looking to trade directionally, which also has a “greek” named DELTA, and if you are just using stock then THETA doesn’t matter and it is only DELTA or being right on the direction that matters. However, when you evolve as a trader you will learn that selling time(THETA) is a great way to create an income or as we call it cash flow. In the cash flow scenario, DELTA is important but less so than if one is only trading direction. This brings us back around to what this means to us when choosing a trading strategy. If we are selling THETA, using strategies like COVERED CALLS, CREDIT SPREADS or IRON CONDORS then this sideways movement can be good for these types of trades. These smaller candles and ranges can make these trades work really well, however, there is a problem and that problem is the other “greek”, VEGA and it affects the THETA effect.
VEGA is volatility. Volatility is a great contributor to the price of options. When the volatility is high then the premium of options is heightened and again this is good for those who sell THETA and bad for those who buy THETA. Here is the issue with this particular set of market conditions, the market volatility in this scenario is lower and therefore there is less pop in the options and so using the above-mentioned strategies are less effective from a price standpoint but tend to work out well because of the lack of trending momentum.
For these market conditions we have some trades that work but also have some challenges due to the effect of some of these conditions on the types of trades we use. These conditions present both problems and opportunities and our job as a trader is to first determine what the market condition is and then what strategy will work best in those conditions. One thing that is sometimes lost on traders is that there is no one size fits all strategy or indicator or system that is going to work all the time and therefore we have to be “fluid” like Bruce Lee when it comes to changing market conditions.
To further the discussion here, if one is trying to use a LONG CALL strategy during the above-mentioned market conditions then it will most likely be a tough go. In next weeks blog we will talk about when the right time is to use a strategy like the LONG CALL.
Give the above mentioned strategies a try in your practice accounts when you recognize that the market conditions are ripe for these types of trades and you may find more success than using other more aggressive strategies.
Until we meet again, Trade Well All!
