Last week we talked about the second market phase and that is breaking out to the trend. This is the phase that most of the investing public looks for. They like those long trending bull markets because they get to see their equity rise and it feels good. For traders this phase can be equally as profitable because of the multitude of good setups that can be found and taken advantage of if one has the skills to recognize and execute solid trading plans.

That brings us to the final phase of any market. This market is usually the most dangerous for most traders and the absolute most profitable for those who understand how and what to trade in this phase. This is what we are discussing this week.

This phase is characterized by wicked price movement an extreme elevation in volatility and a meteoric rise in volume as well. This phase is called the blowoff phase. This phase is represented by one side of the market experiencing total domination and the other side of that same market experiencing crushing defeat. This is also typically the shortest time frame for a market and the least amount of time spent in this phase. I have been using the term market here and this does occur in all markets on all time frames, however, this phenomenon is most easily seen in very volatile equities. As a matter of fact, you will see this more often in the most volatile equities and products.

As mentioned this phase has extreme volatility and this presents a problem for different types of trades. As we spoke about in the first phase, consolidation, volatility that is non-existent can make trading somewhat difficult especially if you are trying to capture premium by selling option contracts, in other words trying to create cash flow. On the flip side of little volatility is massive volatility and it also host some problems. For, example if you have extremely high volatility and you go out a buy a call option and then the overall volatility drops your call option will lose value in the form of premium drop, this means that even if your right on direction but the volatility falls off you can still lose money. This is not fun and it happens alot in the blowoff phase because as was stated the volatility is at extreme levels and although it could go higher as one never knows where the ceiling is the odds are better that it will fall than continue to increase. So, what is one to do in this phase to take advantage of these great opportunities to profit? Well, it starts with choosing the right equities and then making sure the strategies being used are used correctly and plans are firmly in place to succeed.

So let’s talk about the right equities first.

The right equities are ones that have that provide many opportunities for blowoffs. As we stated earlier the most volatile stocks provide the most opportunities and therefore we will be looking for those kinds of stocks. Now that we have established what kind of equities we need to use we need to look at what we can do with them. Let’s think about a long options. If we were to buy a long call with extreme volatility what would be the most likely outcome? With volatility at an extreme then the premium to purchase would most likely be at or near the peak, this will most likely not work out well. This puts long options at a no-go for trading this strategy.

Since the blowoff phase is very aggressive from a directional standpoint we need to go at this phase with that thought in mind from a strategy standpoint. That means we can only use the absolute best strategies to take down the big profits. This means some more aggressive advanced strategies are called for. The strategies that work best in this phase are the risk reversal and the back ratio spread. These are two of the most aggressively directional strategies in the playbook and therefore they are the most rewarding in this phase. These strategies take some experience to get right but they can provide just rewards.

There is one other idiosyncrasy with this phase that is paramount to trading it successfully and that is printed in the name. This phase is a blowoff and if we think of a rocket ship blowing off all of its fuel it at some point it has to turn back the other way. The blowoff phase does this same thing, It has so much energy expended to the one side, that the other side is inevitable and so when the blow-off is finished the turn will come. Now, the turn may be short-lived but it is the most likely outcome of this energy exhaustion.

Now that we have explored the three phases of the markets and what we need to use in each market in the next phase of this blog we will begin to explore each of the trades and see if we can’t identify the phases and put the trades into action!

Stay tuned friends!