Connors’ Weekly Battle Plan
How Not To Get Rich In
60 Days
The ability to
make money in the market over the past two months
has obviously been limited. If you are frustrated by the lack of opportunities,
join the club, because unless you have been a seller of options volatility,
their has been little chance to make substantial profits. This does not mean you
should have lost a lot of money, because you really shouldn’t have. But, it does
mean that the chances to “clean up” just have not been there.
Let’s Look at Some Statistics
Let’s go back two months and see what the market has done:
Since June 4, the S&P 500 cash market has moved a whopping total of six
points through Friday’s close. The range has been in a tight bound 53-point range.
Forty trading days have occurred and incredibly, the up days vs. down days have
been exactly equal…20 days up, 20 days down. Let’s go further. For four out
of the past five trading days, the 10 period ADX (which measures the strength of
the trend) has closed under 15. This has only occurred 16 times before in the
past 10 years. When it has occurred, it has preceded some fairly healthy moves,
such as a 13% loss in the market in the early Fall of 2000, and a 19%, six-week
move in prices in February 2001.Â
So we know that making money has been tough due to the sideways movement for the
past two months. But, (and this is a good but) we know that a large move is
likely near. In which direction will this move take place? Let’s look at some
historical statistics to help guide us. I wrote about the following this past
week in my Nightly Battle Plan Trading Service and I will repeat the information
here for you.
Through Thursday, the VIX has gone 98 consecutive days without making a new
20-day high. This ties the longest streak since the VIX’s inception in 1986. The
other time this happened, it ended on 9/6/00. After the VIX made that 20-day
high, the S&P immediately lost 10% of its value over the next month and a half.
Â
The third-longest period the VIX went without
making a new 20-day high was 72 days ending 8/11/87. This preceded the crash of
October 1987. The fourth-longest period was 71 days ending 1/24/03. From there
the S&Ps fell almost 7% in the following 3 weeks (thanks to my research
assistant Conor Sen for providing me with this information).
We can come to two conclusions here. One is that a large move is due. Low
volatility is usually always followed by high volatility (and vice versa). The
ADX readings provide us with further evidence that this large move is near. This
means that volatility is going to increase and in a second I’ll give you some
thoughts on how to take advantage of this when it does happen.
Second, we know that in looking back, whenever we’ve had sustained periods of
low VIX readings, as measured by the number of days between the VIX making new
20-day highs, the move has been to the downside. In one of the cases (1987), it
preceded a historic crash.
I’m in no way saying we are going to crash or even drop hard. I’m much more
comfortable in predicting that volatility is going to increase soon. So first,
let’s look at one way to take advantage of volatility should it increase and
then we’ll cautiously look at possible ways to take advantage of the market
should it have a sharp, short-term sell-off.
Taking Advantage Of The
Market When Volatility Explodes
Let’s first look at the most efficient means to taking advantage of rising
volatility. That’s done with options — in this case, OEX options. Before we
continue though, please remember that you must be approved by your brokerage
firm to trade options and, because of their leverage, the risks are high when
you trade them.
Let’s assume we are not willing to predict the direction of the OEX, simply that
volatility will increase. There are a number of options strategies available to
you (if you sit on an options desk and trade volatility for a living, you know
some of the best exotic strategies to use), and they can get very complicated,
but let’s keep it simple. You can buy a strangle, which simply means you are
buying a call and a put of the out of the money OEX options. Friday, the OEX
closed at 493.64. You can buy an OEX Sept 525 call and a Sept 465 put for a
combined price of approximately 9.00. When you take this position, you are
saying that prices are going to move in a large way in one direction, and the
increase of the option in the direction’s move will offset the loss you will
take on the side that is wrong. Also, because volatility is a component of the
option’s price, your option has the potential to increase in value due to the
increase in volatility.
Now, let’s go a step further. Let’s assume we believe the market is going to
drop. Obviously just going long OEX puts will be one way to take advantage of
the drop. Not only will price move in our favor, but as we know from the past,
volatility will likely increase during this drop, further helping the price of
our options.
Other ways to take advantage of prices dropping? There are many. Short SPYs,
short e-minis, and short high beta stocks — especially those that have
under-performed the markets rise this year — are a few strategies that are at
the top of the list.
What we’ve done above is put together a structured plan. We’ve looked at
historical data and asked what has the market done following extreme periods of
low volatility. It has lead us to the conclusion, proven by the academic world
50 years ago, that a period of high volatility is likely near. We have then
added another component to our analysis. And that analysis asked, what has
happened in the past, when the VIX has had an extreme period of sideways
movement, as measured by the period between new 20 day highs. And, the findings
show that in most cases, it’s been followed by extreme market weakness.
Conclusion
The conclusion from the above is obvious, but the future results never are.
Having done this for more than 20 years, I will tell you that nothing, nothing,
nothing is remotely close to perfect. Successful trading is a game of looking
for historical edges and hoping that those edges continue to play themselves
out. Should they do this, especially in the above scenario, everyone looks
smart. But the smartest guys, and the ones who last the longest in this game, do
the above analysis, take a stand and then assume they will be wrong. By assuming
they will be wrong, they are put in the position of using protective stops and
proper, conservative position size. When they’re right, they’ll make a bit less
money because they were conservative in their approach. And when they’re wrong,
they’ll lose just a little in order to be around to play again in the future.
The last part of the previous paragraph is why so many people from the late ’90s
are no longer around. A lot of these traders/investors assumed they were always
going to be right. The smarter guys, the ones who are still around (and
likely including you) are around for the main reason that they did their
analysis… and then assumed that they were going to be wrong. It’s the
difference between gambling and professional trading.
Have a great week trading (and look out for the fireworks that are about to
come)!
Â