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Volatile, Non-Trending Periods: Trade More or Not at All

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I went to the mail bag this week to make sure I stuck to a subject on the minds of our subscribers in this wild and crazy period.

SUBSCRIBER QUESTION:
"...any suggestions for trading in periods like this extreme volatility and seesaw action?"

RESPONSE:
The answer I myself first took to heart on this subject is what the chief technical analyst (Bob Farrell) at Merrill Lynch (at the time I was there) used to say about periods like this. It was to the effect of 'trade more or not at all'. When there is heavy volatility and whipsaw action, you either are forced to do short-term trading or stay out and wait for a more definite trend to develop again. After all, the markets only trends in one direction or the other for part of the time, followed by non-trending periods, sometimes long ones.

It seems like an oxymoron to say to option traders that's there a need to do 'shorter-term' trading. But there are degrees of being quicker to get into and out of the market. When trends shorten up, we're looking at the trend that typically unfolds over 2-3 days to 2-3 weeks. In periods like the current situation of extreme volatility, I focus the MOST on the HOURLY oscillators or price momentum indicators that measure the most extreme short-term 'overbought' or 'oversold' situations.

If I don't want to attempt trading the short-term extremes that develop in the major stock indexes or bellwether stocks of great liquidity, I need to determine as best I can the intermediate-term direction, LACK of direction (i.e., sideways) and if there is a sideways trend, is it a trading range that is wide enough and well-defined enough to enable me to buy at the low end and sell at the high end of that price range.

The long-term, month-to-month trend is going to be of lesser concern to options traders EXCEPT as it might impact the intermediate (2-3 week or longer) trend. For example, if the major indexes appear to be bottoming, as may be the case currently, look also at the long-term weekly charts to see if there's something on those charts that help us see if the market is ALSO in an area of potential long-term technical support. Most important is when prices hold at, near or above a prior major low. Second in importance as a forecasting tool for the trend is whether prices hold at, near or above a trendline.

Just as fundamental analysis (e.g., earnings prospects, impact of Fed policy, etc.) of the current market is quite MIXED, so (of course) is the current technical picture.

The intermediate-term trend MAY be turning up, but further price action is needed. In any trend, short (e.g., 2-3 days), intermediate (e.g., 2-3 weeks) or long-term (2-3 months) the trend is DOWN as long as each new low is BELOW the previous downswing low and each rebound following each low, stops BELOW the prior upswing high.
This is the only way to determine the trend direction on a technical basis, but a secondary way to ascertain potential trend changes is by use of trendlines; a decline stops at, near or above an UP trendline, which is followed by a turn up in prices.

Along with trendline analysis, or secondary methods of determining possible trend changes or reversals, is to look at so-called 'overbought' or 'oversold' extremes and to look at bullish or bearish 'sentiment' extremes.

USING SHORT-TERM TREND MODELS:

USE OF THE 21-HOUR RSI (RELATIVE STRENGTH INDEX)
The RSI is a ratio line that measures the 'relative strength' of X number of higher closes VERSUS X number of lower closes. Up or down closes can be calculated on an intraday, daily, weekly or monthly basis. The number of periods is the 'length' setting. If set to 14 the RSI measures 14 closing periods on whatever chart you select; e.g., hourly, daily, etc.

The RSI also attempts to define an 'overbought' extreme as when the RSI registers at or above 65, typically 70, or when the underlying instrument is 'oversold' by registering at or below 35, typically, 30 or under.

The length setting is a key one. For the hourly RSI, I use '21', a fibonacci number and one that I have found best defines extremes that develop after strongly trending periods of a few days. In 3 trading days, there are close to 21 hourly closes.

Sometimes, a bullish or bearish 'divergence' develops where price and RSI trendlines slope in opposite directions. A bullish divergence has prices trending lower as RSI starts trending up; i.e., higher 'relative strength'. A bearish divergence is where prices are trending higher but the RSI is declining on balance.

BUYING AND SELLING OVERBOUGHT/OVERSOLD EXTREMES:
The overbought extremes on a 21-hour basis tend to occur with readings at or above 60 in the major market indexes, such as is seen with the S&P 100 (OEX) chart below; buying index puts only when those extremes were seen and not otherwise, has been quite profitable in recent weeks.

There were more 'overbought' extremes than oversold ones in the period seen below in the hourly chart, which is ideal in a bearish period as more signals occurred on the right side of the dominant trend. The 21-hour RSI 'touched' an overbought reading a week ago, on Wed., the 19th, but it wasn't quite conclusive as I like to see it well into this zone IF I'm going to base a trading decision on this indicator more than on more this PLUS more conclusive price considerations; e.g., a possible double top or that the index has reached the high end of its likely trading range. This more conclusive OVERSOLD reading was reached at the beginning of this week per the last down red arrow on the OEX hourly chart below:

There was ONE oversold extreme seen in the OEX chart above that was a good call entry signal given the oversold extreme below 30. A quick profit could have been realized as the Relative Strength Index approached its common oversold level the first time and a further call entry made when there was a lower low made later on, on HIGHER relative strength, per the diverging trendlines seen above. I don't minimize that fact that is can be quite hard to take that kind of 'signal' in the heat of that highly emotional and volatile week!

The hourly chart of the Dow 30 (INDU) below showed mostly the same overbought extremes, with the exception of one more reading in the 'overbought' zone with INDU, with one other difference: there was a higher relative high made after the first OEX bottom and 21-period RSI didn't diverge from what was occurring with price action; i.e., the trendlines below both slope in the SAME upward direction. The second, higher, DOW bottom might have helped keep you long OEX calls (or to buy them) when OEX fell briefly under its prior low; INDU which often develops the most consistent technical patterns.

As to whether I now want to be in Dow Index puts based on the extreme RSI seen above (when INDU got up to its recent high above 12400), I'm not sure I want to be in Dow index puts, as there are some other considerations I have relating to the INTERMEDIATE to LONG-TERM TRENDS, as well as the extremes in bearish sentiment seen recently which is a next topic. Yes to being in puts based on the record for the period seen above when there were the same RSI hourly upside extremes, but patterns relating to overbought/oversold won't always stay as consistent as that seen on the INDU hourly chart above.

INTERMEDIATE TREND CONSIDERATIONS:

HIGH BEARISH SENTIMENT OFTEN SIGNALS AN OPPOSITE DEVELOPMENT:
To date, there has not been a single rally that has carried above a prior rally high, which would have to come in order to be most conclusive that the intermediate trend had turned; see the S&P 100 (OEX) chart below.

I don't want to go into the theory of why high bearish sentiment often is an indication that the market may be making an intermediate to long-term bottom, even if only an interim bottom that will be 're-tested' later (as in the end of the bear market in 2002-2003). I would just note that the recent very LOW bullish sentiment (high bearishness) seen above, may set the stage for a rally that will carry further than traders expect currently; in all the major stock indexes, not just the OEX, which happens to be the chart I display this indicator on.

INTERMEDIATE-TERM TRENDLINE CONSIDERATIONS:
Another analysis I have made about whether the intermediate, multiweek, trend could be shifting here from down to up is that the S&P has managed to pierce its down trendline (to the upside). The decline today, took SPX back to possible support implied by the previously broken down trendline, so the next couple of days should tell the story on whether a further advance will develop. Where SPX could manage to get above its prior highs at 1388 to 1395, which would be MORE conclusive of a change to a more 2-3 week bullish outlook.

A TECHNICAL MODEL THAT ASSESSES STRONG/WEAK INTERMEDIATE TRENDS:
Pattern recognition, given sufficient experience at it, will often tell you by looking at a chart whether a trend is strongly up, strongly down or just whipping back and forth and maybe setting up a trading range. A TECHNICAL indicator that can help you determine whether an index or stock is 'trending' or not is the Average Directional Index or ADX.
Welles Wilder, who also developed the Stochastics indicator, came up with the Average Directional Index (ADX) to evaluate the strength of a current trend, be it up or down. He came up with the ADX when trading the commodities markets and the stock market isn't as volatile generally so the scale is less extreme.
The ADX is an 'oscillator' in that it fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 50-60 are relatively rare even in the more volatile commodities markets, but in stocks and stock indexes, readings above 35 are unusual. Low readings, below 20 down to 15 indicate a weak trend; readings above 30 in the major stock market indexes indicate a strong trend.
The ADX indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend; i.e., readings above 30 can indicate a strong downtrend as well as a strong uptrend.
ADX can also be used to identify potential changes in a market from trending to a weak trend or non-trending. When ADX begins to strengthen from the 15-18 area and moves above 20, it is a sign of a developing trend. When ADX begins to weaken from above the 33-35 area and then moves below 28-30, it is a sign that the current trend is losing strength.

The current assessment of Average Directional Index (ADX) as seen above, is that of a weak or we could say a still intermediate-term 'non-trending' S&P 500 index. This of course isn't any mystery to anyone closely following recent price action that is so volatile. However, if you have doubt about this or want to 'measure' the intermediate trend direction with an objective type statistical model, you can use the ADX indicator. The 14 'length' setting is the typical default setting for this indicator that you'll see and I don't change from it when I use this indicator and this 'length' setting is close enough to my preferred '13' setting, a fibonacci number.

A TECHNICAL LOOK AT THE LONG-TERM TREND:
If we look at the long-term, multiyear, up trendline for SPX, it has held that line based on my current assessment of where that trendline should intersect. More importantly even, recent lows have to date held ABOVE its (2006) prior low. This suggests to me that the LONG-TERM uptrend could still be intact and this has some influence on my thinking on the current prospects for the market to work higher. A similar chart picture on the Nasdaq 100 (NDX) chart is seen, but not shown here.

Moreover, a long-term oversold assessment based on the 13-week Relative Strength Index (RSI) seen above is another aspect to the current technical picture. This market may not have to go up much, but it may also be resistant to declining much further in the next few weeks. Stay tuned on that!

QUESTIONS/COMMENTS:
Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

GOOD TRADING SUCCESS!
 

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