Going Against the Grain

Waiting for extremes and then selling out-of-the-money options swings odds in your favor.

Mark Twain once said, “I was seldom able to see an opportunity until it had ceased to be one.” Sure, rumor has it Mr. Twain was not a very good trader, yet this poetic phrase makes all the sense in the world. And in sense Warren Buffet, who is regarded as a decent trader, echoed Twain’s bon mot with his famous advice to “be fearful when others are greedy and fearful when others are greedy.”

In essence these statements are expressing the danger of jumping on a bandwagon and conversely the value of being a contrarian in your trading and investment approach. This is especially true on longer time frames and bigger “macro” trends – think avoiding/shorting the dot.com bubble or buying during the financial crisis – but can also be applied to shorter time frames and individual securities.

This has probably never been truer than in the current market environment, which has seen extended periods of narrow ranges punctuated by the occasional spurt above or below resistance and support levels. Such moves are considered “false breakdown/ups” and can be great set-ups for going against the grain.

false-breakout-downs-image-9-28-16

Learning to be a contrarian during market extreme can be difficult. Doing what mentally hurts the most, while everybody else is doing or favoring the exact opposite. Going long during what based on historical statistics is an extremely pessimistic environment offers more attractive potential rewards. When you buy after the market has already gone up 7% in 2 weeks, it is usually too late. When you sell after the market has fallen 7% in two weeks, it is usually too late. Someone said the stock market is the hardest way to make an easy living, for good reason.

We need to look no further back than this June during the “Brexit”. When it appeared February, many swing traders were saying the market should be shorted on a break below previous support at 2002 level. When it broke below 2000 many bears piled in and those shorted quickly had their derrieres kicked as the market catapulted to new highs.

spy-false-breakdown-chart-9-27-16

The point of this simple observation is that applying strategies that give you some cushion for error is usually wise. Strategies like, for example, the much-maligned selling out-of-the-money options. I like waiting for the market or a stock to hit obvious support or resistance and then selling an OTM put or call spread for a credit. The SPY’s recent breakdown right to the old support at the $212 level offered such an opportunity.

When you combine both ingredients; contrarianism and selling OTM options to give yourself enough room for error, while keeping an eye on your risk as a hungry hawk, things tend to work out in your favor in the long run.

It is not the only way to make money in the markets, of course, but it is a decent fit to an environment full of noise, where exactitude is usually superseded by randomness. Alternatively, you can be the old trend follower guy, but be aware of the frustration described at the beginning of this article, and according to that, respect your stop losses, and make small bets, so you can be wrong many times until you finally nail it.

It’s a tough way to make a living, and it reminds me of another famous quip from Yogi Berra and one of his Yogi-isms: “Nobody goes there anymore. It’s too crowded!”

Selling out-of-the money at extremes can be considered entering an empty room and then waiting for everyone to rush in. You get to charge admission and exit with a profit when it gets too crowded.

— Steve Smith

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About the Author: Steve Smith