By Chris Ebert
During a sell-off in the stock market, in which prices are tumbling, who is it that is buying all the shares of stock that are being sold?
Somebody has to buy each stock, or else there would be no trades. Someone has to take the other side of the trade – which is why the term sell-off can be misleading – there is just as much buying as there is selling during a sell-off.
The term sell-off simply means that sellers have lost control of the price and must accept whatever bid price is offered. Sellers are not in a position to haggle during a sell-off; buyers are.
It is important for a trader to understand the reason that folks are buying stocks during a sell-off, because the folks who are buying stocks will have an effect on stock prices in the future. If the buyers have weak hands, they will readily be shaken out of their positions, leading to a speedy continuation of the downtrend in prices. Strong hands, however, can lead to impressive rallies, even when the overall outlook for stocks may appear weak. Some sell-offs lead to vigorous new growth; others lead to further decay, depending on whether hands are strong or weak.
A common method in widespread use among traders looking to decipher whether stocks are moving to weak hands or strong ones during a sell-off is a Fibonacci analysis. The method has its advantages, but also has a tendency to be a bit abstract. The following analysis of the options market is designed to aid a trader with Fibonacci. To begin, it is important to know exactly what types of option trades are currently profitable on the S&P 500 as a whole.
Click on chart to enlarge
* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)
You are here – Bull Market Stage 3 – the “Resistance” Stage.
Click on chart to enlarge
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending October 4, 2014, this is how the trades performed on the S&P 500 index ($SPY or $SPX):
- Covered Call and Naked Put trading are each currently profitable (A+).
This week’s profit was +2.7%.
- Long Call and Married Put trading are each currently not profitable (B-).
This week’s loss was -1.1%.
- Long Straddle and Strangle trading is currently not profitable (C-).
This week’s loss was -3.8%.
Using the chart above, it can be seen that the combination, A+ B- C-, occurs whenever the stock market environment is at Bull Market Stage 3, known here as the resistance stage. This stage gets its name from (more…)