Selling Into Strength, Buying Into Weakness
Apr 2, 2015
A style of trading that we typically use at tastytrade is the contrarian approach, which is to trade counter to prevailing market trends. Basically, contrarian traders always try do the opposite of what the masses are doing in the hopes that they will be one step ahead of the market (they are kind of like the market hipsters, if you will).
At first, I was resistant to the contrarian approach. In my head, it made sense to go along with the crowd and invest more in a stock that was towards the higher end of where it had been trading because if it kept rising, I didn’t want to be the one missing out. Inversely to that, I wanted to sell a stock that was at its lows (in case it went bankrupt).
After a short stint of following the masses, I began to feel like I was always too late with my trades and sought out an alternative approach, which is when I found tastytrade.
One of the mantras frequently used on tastyrade is to sell into strength and buy into weakness, which is a contrarian style of trading. With this post, I wanted to expand on that phrase a little more to make it easier for novice traders to understand.
When an underlying is trading at the high end of its yearly range, or if it has recently made a significant move to the upside, the assumption is that the stock won’t continue to ascend at a rapid rate.
Placing a contrarian trade based on this assumption is known as selling into strength. At tastytrade, we may look to place a trade that profits from a decrease in the price of the stock or even short the stock outright in this situation.
For instance, a trade we would consider to be “selling into strength” would be selling a call spread, since the call spread profits when the price of the stock goes down. This is called betting on the downside - meaning, you are betting the underlying is going to go down. Why is that contrarian? Because the stock is doing really well, and you’re betting that the stock will change direction…against its current upward trend.
When an underlying is trading at the low end of its yearly range, or if it has recently made a significant move to the downside, the assumption is that the stock won’t continue to descend at a rapid rate. At that point, we at tastytrade would look to get long the underlying.
We may look to sell naked puts, buy covered calls, or sell put spreads. When we buy into weakness, we tend to stray away from debit spreads because a decrease in the stock price usually results in an increase of volatility. This is bad for option buyers and great for option sellers. This is known as betting on the upside, or betting the underlying is going to go up. As you can see, this is contrarian because the stock is trending down.
This contrarian approach may be tough to wrap your head around, but it can be an easy way to stay mechanical. Trading mechanically, means that you trade without emotion, and with a concrete strategy in place.
You don’t need to look at the past news or read the underlying’s earning reports to follow the contrarian style. The reason this is a great strategy, especially for a beginner, is because it takes guesswork and emotion out of the equation. I find the less emotional I am about trading, the more successful I am.
One of the final things about the contrarian approach is that there is no caveat. Since a beginner trader may lack market awareness, being a contrarian makes it easy to stick to the strategy ad nauseum, without question, and without doubt until the intricacies of the market become clearer.
Want to learn more about the contrarian approach to trading? Check out the videos here.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
Nov 11, 2015
Here at tastytrade, we have certain guidelines that we generally like to stick to when we trade. One of our favorite tastytraders, Tony from Mexico, came up with ‘trading commandments’, which we thought were too good not to include on our tastytrade blog.
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