Good Day Rookie Bloggers!
We are back with our systems and conditions series after taking a small hiatus to discuss the challenges that we can face with certain brokers depending on where you happen to reside. I hope it was educational for those of you that find yourselves up against the challenges that I spoke of. We can now refocus our attention on the different phases that markets go through and what types of trades work best in each phase.
If you are coming into this blog at this stage then a lot of what I am saying up above may not make a lot of sense and in that vein, I will throw out the Coles notes version of what we have covered so far. I hope the Coles notes thing doesn’t throw you off as well, it was a thing back when I was in school which I must admit was a long time ago and therefore I am unsure if it is actually a thing nowadays? Basically, the Coles notes was a synopsis of a novel that for those who chose not to read said novel could get the gist of what was in the novel or so I have been told.
So here is the Coles notes of this series. There are three phases to any market and they are consolidation, a breakout to the trend and then the blowoff phase. One can think of this as the birth, life, and death of a market and no the market doesn’t actually die but it definitely changes in a big way. In each of these phases, there are certain trades that just work better than other types of trades.
For example, the first phase is consolidation and it is characterized by a lot of back and forth movement between support and resistance and usually stays within a certain price range. This is the phase where the majority of markets spend most of their time. Knowing that this market exhibits this behavior can give us an edge because we can use this back and forth to our advantage by using strategies that don’t depend so much on a direction. Those trades that work well are theta or time decay type strategies like covered calls, naked puts, and iron condors.
The second phase is the breakout to the trend phase and by the words, we use to describe it I think one can tell what might happen in this phase. We are going to use more directional strategies because we expect price movement in one direction or the other. We can use diagonal spreads or straight options like long calls or puts. Also, we can use strategies like the one we discussed in the last blog in this series and that is the back ratio spread. This trade needs movement to be successful and this is a phase that can give us just that.
The final phase of any market is the blowoff phase. This phase does not always come along, sometimes breaking out to the trend can go right back into consolidation and then back out to the trend. However, this phase can be very interesting, it is characterized by aggressive price movement and a lot of active participation and by active participation I mean lots of volume. Because this phase has such aggressive price movement it is possible to collect profits in a very short period of time and with a magnitude of gains if you are on the right side of the move. The move in this phase is basically the exhaustion of a directional move. If the move is to the upside then you will see a tonne of volume because the bulls are piling on and bears are crying to get out of their short positions and this makes for fireworks!
This massive movement lends itself to using a number of different trades such as long call or long puts or back ratio spreads etc. The key is to use a trade that is aggressively directional. In these types of trades, we want open-ended reward and limited risk if at all possible. The reason this is called the death of a market is that when all this movement is finished in one direction and the players are exhausted, meaning the buyers have bought and the sellers are out of their painful positions then what usually happens is the direction reverses and this is when we want to get in with our aggressive directional trades as this is where opportunity lies to collect those quick gains. Typically the reverse move is sharp and can be short or sustained and in either case, we can be ready to reap the rewards. So this is the final phase and there is one more trade that I find particularly good for this type of action and that is called the risk-reversal. This trade acts like a long call or long put but lessens the overall risk.
I want to spend a little bit of time on this trade as it is a bit more advanced but it can be a good trade to take advantage of these market conditions. So in next week’s blog, we are going to go through this trade and all it entails and what it means for us and then we can put on a mock trade and see it through. I will also show some examples of a blowoff pattern so that we will be able to spot these conditions as they happen.
So until next week, I urge you to go back and review the past issues of this blog series so that you can catch up and be ready for the final push!
Happy Trading All,