A Strategy For Playing Large-Range Days

Many commonly held assumptions regarding chart analysis sound perfectly reasonable and logical until you subject them to close scrutiny.

For example, conventional wisdom states that large one-day moves immediately continue in the direction of the move. My research, however, indicates otherwise.

Markets that make big one-day moves attract attention. For example, when the Dow makes a large move (100+ points), most news channels carry the story, most newspapers make it the lead business story, and every market analyst and guru explains why the move will almost certainly continue. But looking closely at large one-day moves reveals that the vast majority of time markets do not follow through after these moves--they move sideways!

In studying this phenomenon, I looked at large-range days and the price action that followed them in the T-bond market over a two-year period--specifically, those days when the market closed two standard deviations (see Table 1 for the calculation) from its previous close. Such moves occur approximately one out of every twenty trading days.

Most of the time the market didn't follow through the in the next few days following the large-range day. In fact, from a directional viewpoint, you could flip a coin as to whether the move would be up or down the next day. Just as importantly, the market often closed near the closing price of the large-move day three to four days later.

Here is how to calculate a two standard deviation move in bonds. We will assume bonds are trading at 110 and their 100-day historical volatility is at 10 percent. 10% H.V./Square Root of 265 trading days = .6250% .6250% x 110.00 (bond price) = .6875, or 22/32 22/32 x 2 (Standard Deviation) = 1.375, or 1 12/32 110.00 + 1 12/32 = 111 12/32 110-1 12/32 = 108 20/32

Table 1. Calculating a two standard deviation move T-bonds.

Now, let's apply this to the real world. It's human nature to get caught up in the hype and trade in the direction of the move. Worse, many traders are inclined to do so with options. Unfortunately, these options will be grossly overpriced because of the increase in implied volatility caused by traders' excitement over the move. Not only is there a high likelihood the move won't continue (causing time erosion in the options' value), but even worse, you are buying overvalued options! You have the worst of all worlds.

The smarter strategy is to sell the overpriced options via a naked combination. You can sell calls that are one standard deviation from the large-range day's high and the puts that are one standard deviation from the large-range day's low. If the market moves sideways the premiums on both sides will collapse. (A word of warning: In strongly trending markets (ADX 25 or higher), this principle does not hold true. Our research has found it works best in non-trending markets.)

In conclusion, when markets move two standard deviations from their normal volatility, the reversion to the mean principle will kick in and the market probably will take a few days to rest. As a result, markets tend to move sideways rather than further in the direction of a large-range day. Such situations are good opportunities to sell overpriced options and benefit from imploding volatility.