Long-term up trends eventually succumb to a buying frenzy. The market establishes such a strong, predictable rally that investors get overconfident and they plow money into stocks. As they do so, prices become vulnerable to a sharp decline. An unforeseen political or economic event blindsides traders and uncertainty creates chaos. As the market falls, some of the froth is taken out when overexposed speculators and investors bail on their positions. Fear flows through the market as traders try to adjust their risk and gauge the magnitude of the news. Eventually, the impact is quantified and traders realize that the long-term bullish conditions are still intact. As long positions are reestablished, a snap back rally materializes. Bulls start aggressively buying stocks and bears run for cover as they try to buy-in short positions. A sharp market decline followed by an equally sharp rally is referred to as a “V” bottom. In this series of articles I use the sharp decline in 1997 as an example.
These moves can be broken down into stages. I have written a series of articles on the topic so that you can develop a game plan when they unfold. In the first stage, you need euphoria and excess speculation. That only comes after a long-term bull market. Once a couple of key support levels are breached, traders start to have doubts and fear sets in. In Stock Option Trading Strategy For “V” Bottoms – Leg 1, I set the table and I tell you what to look for.
As a trader, you have to respect what the charts are telling you. Once key horizontal support levels and significant trend lines are broken, you need to adjust your positions. In the article Stock Option Trading Strategy For “V” Bottoms – Leg 2, I describe my actions. There are key price behaviors that you need to be aware of and it is wise to buy options at this stage.
If the market breaks another key support level, it enters the next phase of the decline. At this juncture, you are trying to assess whether or not the move is legitimate. The market could continue to decline much further, or it could snap back. It is critical for you to have a game plan with a defined set of entry and exit points at this stage. The option implied volatilities are elevated and if the market bounces, naked put writing is the best strategy. I write about this critical stage in Stock Option Trading Strategy For “V” Bottoms – Leg 3.
At some point, the market will break through a minor resistance level and hold. That is a sign that the worst is over and that the market will soon resume its rally. Market conditions will change quickly and you need to have your strategy in place. Orders need to be entered in advance since a major rally can come at any time. In Stock Option Trading Strategy For “V” Bottoms – Leg 4, I discuss this tactic.
In the final installment of this series, Stock Option Trading Strategy For “V” Bottoms – Final Leg, I discuss how to adjust your remaining positions so that you can prepare for the ensuing rally. Technical analysis will help you determine the various stages. At each juncture you need to use the optimal strategy.
As a trader you can never discount market declines. These conditions might only exist for a few months, but I have seen them wipe out many traders in the process. During the first 5% of the decline, most people are able to stomach the risk. By the next 10%, everyone is running for cover. In the beginning stages you don’t know if this move is the sign of a market top. You have to protect your capital and adjust. There is a good chance you’ll be able to make money on the way down and if you follow the key signs I have outlined, your biggest gains will come on the snap back rally. The “V” bottom formations take place over a matter of months – they do not linger on. The macro conditions need to be intact for the market to resume its rally. In a matter of years, the move is a mere blip on the chart. However, traders that went through the period remember the bloodshed. A decline that fails to snap back is the sign of a market that is starting to roll over. Look for the warning signs and let technical analysis be your guide.