Last week we went through the most common market conditions that we will see overall from a market perspective. It would seem logical that if the market stays in a certain condition most of the time then perhaps we should put a lot of focus on how to trade those market conditions. It might be in our best interest as traders to understand those market conditions and how to trade them effectively if we wish to make money in that environment? This is what we did last week, we broke down the conditions of that market and looked at what metrics we have to deal with and how those will affect certain types of trades.
We talked about a few different strategies that work well in the environment with the aforementioned metrics in play. Those strategies are the ones that benefit from smaller price ranges and lower volatility. This sideways lower volatility environment occurs a lot of the time in the market, especially when the market is creeping higher which is a characteristic of the market in general. If you look at the time it takes for a market to rise versus the time it takes for a market to fall over history one would see that the market creeps up a lot more than it plummets lower.
That was last week, what has this week go in store for us? Well, we are going to look at the second longest market condition this week and see what it means from a strategy standpoint. The second phase of the markets is the trending phase. This is where the market is moving higher or lower and exhibiting a technical trend pattern known as higher pivot highs and higher pivot lows for an uptrend and lower pivot highs and lower pivot lows for a downtrend. This is a natural progression from the sideways trend that we discussed last week. In the sideways trend, the price action tends to bounce between support and resistance on a regular basis. This is the classic definition of congestion or consolidation.
This is the first phase of any market, this is where markets are born.
To get into the second phase of the market we need one of those support or resistance levels to break and more importantly stay broken. You might be asking yourself, what does he mean by stay broken? What I mean by staying broken is that if the support or resistance is broken but then retraces back below or above that level then it is not staying broken and this would be what is called a fake out or a false breakout. This fake-out negates the second phase of the market known as the breakout to the trend. This second phase is where the price of the entity moves in one direction or the other. This is how a trend is defined, higher prices or lower prices.
This second phase is characterized by momentum and price movement.
The breakout to the trend is where the common investor is in their glory. The investor gets to sit back and watch the price move in a certain direction and watch their net worth increase. This is where the direction is in play and where we need to be cognizant of the “greek” DELTA. DELTA can be considered the same as direction. In addition to understanding DELTA, we need to be mindful of VEGA and THETA to a lesser degree. With a breakout to the trend, you can have two scenarios, one where the volatility is through the roof and rising or the more common scenario where volatility and volume are on the lower end. VEGA will most likely be increasing and decreasing during these directional moves and therefore we need to understand what that will do to our specific type of trade. For example, if you are trading a long option then you need to understand that if the VEGA is increasing then your option will gain in premium value and if the VEGA is decreasing then your option losses in value. One needs to understand this and plan accordingly when choosing your trade. Now, we come to THETA, time decay is always in play and we need to plan for that effect as well. Let’s think of it this way, if you have a long option and it is losing the value you day by day then you better have a good idea of when the move one is expecting is going to happen.
So, with these characteristics in mind, what kinds of trades are going to most beneficial for this market type? Well, whatever we choose, it needs to benefit from the increase or decrease in price and also benefit from an increase in volatility. So, what can meet those criteria? We talked about credit spreads in the first blog of this series and this strategy can work in this particular set of market conditions. There are directional plays that work well in this market phase as well, such as calendar spreads and diagonal spreads. One can do long calls or long puts in this phase as well but be mindful of the time decay effect. Things that will not work as well in this trending phase are iron condors and other neutral type strategies that don’t have the ability to exploit the consistent price movement. There are some more advanced strategies that can work as well such as back ratio spreads or debit spreads. It’s the price movement in this phase that allows a trader to prosper and you only need to select the right trade to take advantage of this movement.
This breakout to the trend phase is great for opportunities but there is another phase that can be even more profitable than the trend phase. The next phase is the blowoff phase and we will delve into that phase next week and this is where things can get really crazy from a price perspective but can be the most fun and the biggest opportunity to cash in trades.
Until next week … trade well my friends.