On Wall Street, it is fairly common for managers of large mutual, hedge and pension funds to create new strategies for their annual investment goals, followed by a rebalancing and optimization of their existing portfolios. At mid-year, around June, many investment managers will then adopt a wait-and-see approach, content to sit tight and do nothing, which can make it next to impossible to find a strong trend to trade for those of us who can't afford to take the summer off.
This can make summer trading a challenging time for stock traders as trade volume begins to decline when these major players (the sell-in-May-and-go-away crowd) go on vacation or seek distraction elsewhere.
If your strategy is based on trend identification — and many strategies are — this can create a debilitating pattern. Several traders are focused on selecting the strongest stocks that are likely to gain in an uptrend or the weakest stocks that will lead the decline amid falling prices.
Making matters worse, according to Stock Trader's Almanac, the so-call "summertime rally" is the weakest of the four seasons and is prone to end-of-month portfolio pumping where larger funds attempt to push the market higher by bidding up shares only to see them later become range-bound once again.
The consideration then, is whether to sit out summertime trading entirely or to adopt a strategy to take into account all of these factors. Thankfully, the solution to remaining financially engaged in the markets is accessible and productive.
Understanding the dilemma
If you are a holder of a given stock whose price action suddenly shifts from a period of expansion to one of contraction, the dilemma you face is whether to sit it out in the hopes that the stock will, at some point, continue in a favorable direction, or if you should exit the trade altogether. Sadly, this is where a lot of traders fall apart in that they either don't have a set of rules to dictate their actions beforehand or they will just wing it and decide as time passes. Of the two possible alternatives, the latter is the most dangerous and, unfortunately, the one most chosen.
In this scenario, the two possible choices — hold or sell — put the trader in the position of not only wrestling with how to make the best choice possible given the situation, but they also create all kinds of psychological conflicts involving emotions such as fear and greed. It's easy to have strong feelings of fear of potential loss by exiting the trade too early to avoid the negative emotional aftereffects while, at the same time, wanting to stick it out because there is the hope that the stock might go on to make you a sizable profit.
However, the good news is that you can tailor your approach to avoid these types of mental/emotional positions while also designing an optimal position to collect income and, at the same time, minimize risk and increase the odds of success.
The summertime doldrums option spread strategy was developed to adapt to the range-bound price patterns that are commonplace during summertime trading by using options to form effective income spreads. These spreads are based on proven statistical edges to help increase your probability of success and avoid unnecessary losses.
The cornerstone of using this strategy correctly is understanding how to filter out bullish and bearish option spread trades by utilizing the 200-day simple moving average (see "Stagnant Apple," below).
In the book, "How the Stock Market Really Works," Leo Gough approached trading the stock market using statistical analysis. He did this by studying what actually worked in technical analysis with the goal of quantifying key statistical edges that can give the speculator a competitive advantage. One of the things Gough put to the test was the trader's adage that, "Bulls live above the 200-day SMA and bears live below it." What he found was a grain of truth in the old saying that, by using the 200-day SMA, you could identify a directional bias in the short-term.
Simply, if price action is above the 200-day SMA, then use a bullish option spread strategy. If price action is below the 200-day SMA, then you want to use a bearish strategy option spread.
But while a 200-day indicator provides the big-picture analysis that is necessary for this trade, it is an imprecise timing tool. Thankfully, the researchers also found that using a short-term relative strength index (RSI) helped identify short-term oversold/overbought areas in the stock's price action (see "Support bounce," below).
To further increase the odds of a winning spread trade, use key readings of a three-period RSI at the point of entry at support/resistance levels. You gain an edge by exploiting the price reversals as price snaps back in the direction of the dominant trend as indicated by which side price is trading on the 200-day SMA.
Look for readings below level 10 on the three-period RSI at price support for a bullish trade and above level 90 at price resistance for a bearish trade.
The approach is defined as follows:
- Based on historical market behavioral tendencies, this trading approach is designed to work best from the beginning of May until mid-August.
- Use the 200-day simple moving average (SMA) to tell you whether the market has a bullish or bearish directional bias.
- Look for points of price support or resistance to set up a bullish put spread or bearish call spread.
- At the point of entry, the three-period relative strength index (RSI) must be below a reading of 10 for a bullish trade or above 90 if it is a bearish trade.
The option strategies
The bullish put spread and the bearish call spread are income-generating strategies that capitalize on the back-and-forth trading that is commonplace during this summer seasonal pattern.
The bullish put spread is used when you determine the market has a bullish bias where price is range-bound or rising. It is implemented as follows:
- Sell an at-the-money (ATM) or in-the-money (ITM) nearby put to collect the premium.
- Buy a cheaper out-of-the-money (OTM) nearby put to hedge against a sudden downturn in price.
The bearish call spread is used when the market has a bearish bias and price is either range-bound or falling. It is implemented as follows:
- Sell an ATM or ITM call to collect the premium.
- Buy a higher-priced OTM call to hedge the risk of a sudden upturn in price.
A recent bearish setup was close to being initiated in Compass Minerals as of the end of June (see "Call to arms," below).
You want to pick an option at least 30 days out so that you can obtain a good risk/reward ratio by collecting enough of a premium on the option sold while still protecting yourself with an OTM option at the same expiration.
The benefit of this strategy is that you are selling a higher price option to collect the premium and then letting time decay decrease the value of the option itself. This puts time on your side while the lower-priced OTM option you purchased acts as a form of insurance to protect you if the directional bias should change and move against you, especially in the event of an unforeseen so-called "black swan" event.
Enhancing the trade
There is a saying that directional option traders have big stories about the huge fortunes that they made in the blink of an eye, but option spread traders sleep better at night and drive nicer cars. This is probably grounded in some truth. In general, directional option traders take long or short positions to take advantage of the tremendous leverage that stock options offer, but often they lose as much as they make even when factoring in the infrequent huge runaway winner.
However, you can enhance the performance of this spread strategy with slightly higher risk by entering the trade at the close of the market if the RSI readings are within their key price levels to set up the trade. Often, it is at these levels that there is a short-term snapback in price that acts as a catalyst to move the stock back in sync with the dominant trend.
Also, keep in mind that, according to the research quoted in this article, the stock market has greater upward bias vs. the downward bias. Translated, the market has a greater proclivity to go up rather than down, so over time you should achieve greater returns by using this strategy primarily on stocks that are trading above their 200-day SMA and avoiding stocks that are trading below it.
Finally, keep in mind that if the stock's price goes strongly in your favor after you implement the setup, you don't have to wait for the expiration date to close out the trade. As price moves in your favor, the premium on the option that you sold will begin to lose value. This gives you the opportunity to buy it back cheaper and bank the difference with a quick profit.
Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, a site dedicated to helping traders learn innovative trading strategies for greater profits and performance.