While a previous article in my option spread trading series explained how to use basic technical analysis indicators to identify market trends, this write-up will cover trend following and trading in non-trending markets.
Each strategy has its pluses and minuses. The brief descriptions below will help to explain each strategy’s strengths and weaknesses.
Trend following means choosing trades that align with the direction of trend lines. This strategy is a good way to stack the odds of achieving a profit in your favor. When the trend lines point upwards and define a bullish trend, we want to pursue bullish-oriented trades. When the trend lines are pointed downwards for a bearish trend, our trades should be oriented to profit from going short.
In a series of eight previous articles, I have described 29 different option spread trading strategies and I have indicated for each strategy whether it is best suited for bullish, bearish or neutral markets.
There is a good reason for sticking with the trend instead of trading against it. When you trade options that require the prices to move against a major trend, you have a much shorter time frame for the trade to be profitable.
Trading on the bearish side of the precious metals market from 2001-2006 is an example of why you should not trade against the trend. Though there were many dips in the metals market, the general direction was bullish. To execute profitable trades against the bullish trend, a trader had to be very precise in picking the right entry point and the right exit point.
For the silver market, the entry and exit points often had to be exact to the day and even hour for a counter-trend trader to make a profit. Experienced investors who are dedicated full time to options trading could make those kinds of transactions. However, most investors do not have the time commitment and skill needed to choose the times and price points accurately.
As I indicated in the previous article on establishing trend lines and trend channels, a non-trending market — also known as a neutral market — is a market without a definite trend in either direction, up or down.
This means that straight calls and puts will often expire worthless, with traders losing the premiums paid and the commissions. While the premiums and commissions are generally small amounts, you could lose a considerable portion of your portfolio if the neutral market persists.
Non-trending markets do not show a clear market direction over prolonged time. These markets are characterized by lower volume and limited price movements that last a short time in either direction. Trend lines will show minimal angles of ascent for defining a bull market or descent for defining a bear market.
Trading in neutral markets could be disastrous for investors who trade only straight call and put options. However, option spread trading is well suited to maximize your chance of earning a profit even in neutral markets. Once you learn how to use spread trading to handle non-trending markets, you might look to operate in non-trending markets only.
The 2004-2007 section of the cotton index chart above shows a non-trending market. In these types of markets, virtually any of the option spread strategies for neutral markets would have much higher probabilities to yield above-average profits compared to trading straight call and put options. A trend line would have been flat or horizontal, showing that neutral strategies were the way to benefit.
Trading against trends
The simple advice is to follow the trend and I generally follow that simple rule. However, if I decide to trade against the trend, I will do so on two conditions only.
- If there is a parabolic rise in the price of a security. Parabolic rises always end in a severe drop after the peak of the rise. This is one of the rare absolutes in trading. Whenever you see a parabolic rise, load up options on the short side, because when the price peaks, it will fall hard almost instantly.
- If negative news hit a stock or a security unreasonably hard. This tends to crush a stock for a very brief time, but it will almost immediately bounce back. While this criterion for trading against the trend is quite reliable, I use it to trade against the trend only occasionally.
Trading with the trend makes picking the entry and exit points far less important because time becomes our ally. If we choose to run against the established trend, we have a limited time to execute a profitable trade. It is certainly possible to get our timing accurate enough to generate a profit in counter-trend trading. However, the additional work we create for ourselves and the increased risk are rarely justified.
If we choose to follow the trends, the price movement can often provide a margin of error that will allow us to miss the exact entry and the exist points and still make a profit. When we are trading opposite the trend, we have no margin of error. A single counter-trade gone wrong can wipe out patiently accumulated gains instantly.
Now that you know how to identify trends, I will discuss in a future article a few basic tools you need to select the stocks or commodities.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.