Directional Trading: Analyzing Price Extremes
Aug 1, 2018
Many stock traders, whether they be short-term or long-term holders, search for extremes in price movement when filtering for opportunities.
For example, a company you like may get beaten up due to bad news or earnings, which you may consider a buying opportunity. On the other hand, irrational exuberance can sometimes push stocks to values viewed as too rich, which can attract short-sellers.
If you do like to trade price extremes in stocks, or are considering doing so in the future, a recent episode of Market Measures is worth a few moments of your time.
The focus of the show is substituting naked options in place of naked stock when a potential buying/selling opportunity arises - especially those that are based on an extreme move in the underlying price.
It should be noted that naked options do represent a different risk profile than naked stock, and traders should ensure that they have fully analyzed the risk profile of each before choosing one over the other.
Getting back to the matter at hand, the Market Measures team investigated this topic from a couple different perspectives.
One question they were seeking to answer was whether there exists a differentiation in this trading approach when one focuses on absolute percent move in an underlying stock, or simply looking at the number of consecutive trading days that it has moved up or down.
This analysis was then conducted for instances in which stock the stock suffered an extreme price decline, as well as when it saw an extreme price increase.. The goal was to evaluate historical performance (through backtests) that would help illustrate whether one approach worked better than another.
Essentially, the team evaluated four different scenarios:
selling puts (i.e. getting long delta) when an underlying suffered an extreme move down in absolute percent terms
selling puts (i.e. getting long delta) when an underlying suffered consecutive down days (1, 2, or 3 consecutive down days).
selling calls (i.e. getting short delta) when an underlying increased rapidly in absolute percent terms
selling calls (i.e. getting short delta) when an underlying increased rapidly over consecutive up days (1, 2, or 3 consecutive up days).
Given the breadth of this study, we recommend reviewing the complete episode of Market Measures for a complete breakdown of both the parameters of the analysis as well as the findings.
However, in order to provide you with proper context on this investigation, we wanted to quickly review a snapshot of information from the episode.
The graphic below highlights the findings from bullet point 2 - selling puts (i.e. getting long delta) when an underlying suffered consecutive down days (1, 2, or 3 consecutive down days):
In the slide above, first notice first how the findings are presented. We have the win rate and average P/L for "all trades" included in the study, and then we have the same data divided up according to which “down day” the trade was initiated (1, 2, or 3).
Looking at the far right column, which is the "third consecutive down day," we can see that the win rate and average P/L for this trading approach (selling puts at a lower price extreme) exhibited the most attractive performance stats. This is certainly insightful information for traders that filter for long delta opportunities in beat-up names.
The balance of the episode includes a review of the other 3 scenarios (outlined in the bullet points) and a full breakdown of the associated performance of those three approaches.
At the very least, we believe the findings from this study will give traders a better idea of how stocks tend to behave when they are trending up or down. The type of insight that can be applied not only to stock and option trading, but also to a scalping strategy.
If you consider implementing a strategy that involves selling naked puts or calls (in place of stock), we recommend “mock trading” these ideas first, so that you can observe how these type of positions perform, and better understand whether they fit your outlook and unique risk profile.
Before getting involved, we also recommend taking the time to review the complete episode of Market Measures when your schedule allows.
If you have any questions about trading naked options in place of naked stock, don’t hesitate to leave a message in the space below, or send us an email at email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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