Buy The Dip Is Now Sell The Rip

by Chris Ebert, Zentrader

This article appeared originally at vetr.com

A buy-the-dip type of stock market is a classic example of a market in which the age-old advice, Buy low – Sell high, actually works. Unfortunately, many traders learn too late that buy-the-dip, the dip referring to a temporary decrease in stock prices, is not always an ideal strategy; and worse yet, there are times when it can be a devastating strategy, ruining a trader financially, psychologically, or both.

It is therefore important to recognize ideal times for buy-the-dip trading, and perhaps more importantly, times that are not ideal.

• There are times to buy each dip,
• there are times to sell each rip,
• and there are times to do both.

A simple analysis of some common stock options can guide a trader to the correct time. First, regardless of whether a trader uses stock options or has no idea how stock options operate, it is important to know which types of options are profitable at the present time.

All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an ETF that closely tracks the performance of the S&P 500, specifically the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). All options are ATM-when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on a Long Call would represent a 3% profit if $SPY was trading at $200, even if the call premium itself actually increased 50%, 100% or more)

You are here – Bull Market Stage 2 – the “digesting gains” Stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending August 2, 2014, this is how the trades performed:

• Covered Call and Naked Put trading are each currently profitable (A+).
  This week’s profit was +3.7%.
• Long Call and Married Put trading are each currently profitable (B+).
  This week’s profit was +2.3%.
• Long Straddle and Strangle trading is currently not profitable (C-).
  This week’s loss was -1.5%.

The reason it is important to know which types of option trades are profitable, right now, is that certain combinations of profit and loss on options only exist in very specific stock market environments. Some combinations favor buy-the-dip trading; others do not.

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 2, known here as the digesting gains stage. This stage gets its name from the tendency for stocks to experience periods of gains interspersed with relatively minor pullbacks, each temporary pullback being the market’s way of digesting the prior gain.

Bull Market Stage 2 is a Time to Buy the Dip and Sell the Rip.

A market that is digesting gains is often said to be both a buy-the-dip and sell the rip opportunity. Every time stock prices rally, or rip, is a selling opportunity since it is likely prices will pull back slightly to digest those gains, forming a temporary dip, or buying opportunity.

While a simple buy-the-dip strategy (also known as a buy-and-hold strategy) may work well in Bull Market Stage 2, since the overall trend is usually towards higher stock prices, selling the rip in addition to buying the dip can provide superior profits if the trades are timed correctly.

There is always a risk in selling the rip, since prices are not guaranteed to pullback and digest each gain, and sometimes climb higher without digestion. Even so, a trader is not required to sell 100% of their position on a rip, so lightening positions on a rip allows a trader to sell the rip without giving up all future gains if a dip fails to materialize. Selling on a rip also frees up trading capital that can be put to use on the next dip.

Other Bull Market Stages

• Bull Market Stage 1 – buy the dip only
  Bull Market Stage 1 is the most bullish of all Options Market Stages, known here as the “lottery fever” stage for its euphoric, lottery fever-like rallies. Selling the rip can be very risky during Stage 1, thus it is often a better time to simply buy the dip, or buy and hold.

• Bull Market Stage 2 – buy the dip and sell the rip
  Stage 2, the current stage, in which the stock market is “digesting gains” is both a buy the dip and sell the rip opportunity, as mentioned above, but favors buying the dip for the reasons given.

• Bull Market Stage 3 – sell the rip only
  Bull Market Stage 3, the “resistance” stage is by far a sell-the-rip environment. For several weeks after Stage 3 has been reached, stock owners are inclined to bail out on any sign of strength. This is especially evident when those who bought stocks at their highs try to get out of their positions at break-even when prices return to those highs after a significant drawdown. Brick wall resistance at those highs is common

• Bull Market Stage 4 – buy the dip and sell the rip
  Bull Market Stage 4 is widely known as a Bull-market correction. As long as it is just a correction, it is a tremendous buy-the-dip opportunity. Of course, since the tendency is for stocks to head down, usually all the way to a major support such as a 200-day simple-moving-average, there can also be opportunities to sell any rip on the way down to that support level.

• Bull Market Stage 5 – buy the dip only
  Bull Market Stage 5is the “all clear” stage once stocks have bounced higher after correcting all the way down to a major support As long as stocks do not breach that support level, Stage 5 is one of the best buy-the-dip opportunities a trader can get during a Bull market. The only risk is that the bounce off of support is actually a “dead cat bounce” in what later turns out to be a Bear market. Even so, good risk management, including meaningful stop-loss orders, can help a trader buy the dip more safely.

Zen and the Art of Swimming Pool Maintenance

Think of the stock market as if it was the typical backyard swimming pool. Filled with fresh, clean, sparkling clear water, it is there for its owner to enjoy, reaping its benefits on any hot summer day.

It is also there for millions of individual algae to enjoy. Certainly the owner can make the water uninhabitable, such as with the addition of chlorine or other chemicals. But, if the pool is uninhabitable for microscopic algae, it is likely not safe for human contact.

Big, powerful traders, for example large institutional traders, are like the swimming pool owners. Individual retail traders are like the algae in the pool.

If the stock market is an uninhabitable pool for individual retail traders, the algae, it is also uninhabitable for the big ones, the pool owners. Strange as it may seem, the big institutional traders need the small individual traders to survive. They need the pool to be enjoyable for algae, lest they make it unenjoyable for themselves.

Shock Treatment

Just as you or I, the individual trader, know the value of buying the dip and selling the rip, big powerful traders do too. The only difference is that these big traders can, by the effect of their sheer size, create their own dips and their own rips. To enjoy their swimming pool (stock market) these big traders (pool owners) shock the pool to create dips (make the pool uninhabitable) for us individuals (algae) until a good number of us leave the pool by giving it back to the pool owners when stock prices have fallen too far for the vast majority of us to bear the harsh environment.

Big traders create a dip, or at the very least create conditions conducive to a dip, then take a dip in the pool, by buying the dip they themselves induced. In this sense, the stock market is rigged, inasmuch as a swimming pool is rigged to suit its owner. Estimates of the exact amount of influence these big traders wield is debatable. It is conceivable that their combined influence could be quite large if they conspired, though it is difficult to fathom such conspiracy theories without developing a craving for tin foil clothing.

Powerful traders create dips in stock prices by withdrawing their funds, in other words by selling their stocks. They do this when the pool accumulates too much algae, as it were. Millions of individual traders around the world are not inclined to give up their stocks when they are sitting on a pile of profits, when the pool is great. If anything they are inclined to beckon their friends and family to jump in as well.

When the pool is such a comfortable environment that the algae are beckoning their friends, that is the perfect time for the pool owners to quietly slip away, leaving the pool to only the algae, as they plan to make the pool uninhabitable for a time, in order to take the pool back for their own enjoyment once again.

If the pool owner made a highly visible escape from the pool, the algae might be inclined to get out too, as it would be obvious to the algae that the environment was about to become harsh. As it turns out, the pool owner doesn’t need to worry too much about tipping off the algae to their impending doom, since many algae find it difficult to leave the pool when it is nice and comfortable, no matter how valid the rumors of doom might seem. How does one justify selling all their stocks (getting out of the pool) when a Bull market has been running unimpeded (when the water’s warm) for several years?

Options Sound the Alert

As indicated above, certain Bull-market stages are conducive to buying the dip, others to selling the rip, and still others to both buying the dip and selling the rip.

Stage 3, the “resistance” stage is unique in that it overwhelmingly favors selling the rip, not only during Stage 3, but in the weeks that follow.

Thus, when Stage 3 is reached, individual traders (algae) must ask themselves whether the powerful traders (pool owners) are indeed still in the stock market (swimming pool). If the owners are not in the pool, then the “sell the rip” mentality is almost certain to spread, gaining momentum as it does. Without the owner’s presence, the algae have little chance of survival when the pool becomes uninhabitable. Sell-the-rip can quickly turn into a major downturn in stock prices when millions of individual traders suddenly realize there is nobody willing to buy the stocks they are so desperate to sell.

Just because Stage 3 has occurred does not necessarily mean the owner has left the pool, though it is always a possibility. Rather, it sometimes means the owner is getting out of the pool. If so, it is likely these powerful traders will get out at the best opportunity, selling their stocks on a rip, just like individual traders are prone to do after Stage 3 has occurred.

Thus, once Stage 3 has begun, it is vitally important that a trader pay attention to recent high prices that occurred just prior to Stage 3. For, it is at those high prices that powerful traders are likely to bail out, if they are going to bail. Brick-wall resistance, which occurs when stock prices move back towards previous highs but cannot exceed those highs, is very telling.

If the market reaches Stage 3 and later re-tests the highs, only to fail after several attempts, it is likely the owners are not in the pool. On the other hand, brick-wall resistance that eventually breaks down is a strong indication that the pool is still habitable, and the owners are still in it.

Failed attempts to break down a brick wall often appear as specific patterns on a price chart. The simplest pattern is a double-top, in which stock prices return to the previous high but soon fall back without exceeding it by any significant amount. A similar pattern involves a head-and-shoulders, in which stock prices rise and hit a brick wall (right shoulder) at nearly the same level as a recent high (left shoulder) despite briefly exceeding the previous high in between (the head).

Both a double-top and a head-and-shoulders pattern can be particularly indicative of a reversal of a Bull market, at least temporarily, when these patterns occur during or soon after Options Market Stage 3. When they do, it’s likely the algae (individual traders) are in the pool (stock market) alone (absent the typical support of large and institutional traders).

If only the algae knew when to get out of the pool, they could enjoy it just as safely as the pool owners.

Weekly 3-Step Options Analysis:

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (#CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here, nearly 3 full years later, in 2014.

As long as the S&P remains above 1810 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls retain control of the longer-term trend. Below S&P 1810 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were in control.

The reasoning goes as follows:

• “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.
• “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.
• “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (#LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks and months. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the price stock sellers are able to obtain from buyers.

As long as the S&P closes the upcoming week above 1920, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1920, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss of confidence by the Bulls. Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.

The reasoning goes as follows:

• “If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, they are also showing their strength.
• “If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (#LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

The LSSI currently stands at -1.5%, which is normal, and indicative of a market that is neither in imminent need of correction nor in need of a major breakout from the trading range of the last few months. Positive values for the LSSI represent profits for Long Straddle option trades. Profits represent an unusual condition for Long Straddle trading, one of three unusual conditions that warrant attention.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

* Any profit * Excessive profit (>4% per 4 months) * Excessive loss (>6% per 4 months)

Long Straddle trading (and Long Strangle trading) will not be profitable during the upcoming week unless the S&P closes above 1974. Values above S&P 1974 would suggest a return to the recent euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2049 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1863 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a break higher from 1863 would be a major bullish “buy the dip” signal, while a break below 1863 would signal a full-fledged Bull market correction was underway.

The reasoning goes as follows:

• “If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.
• “If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.
• “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to [email protected]