The Guacamole Dilemma in Options Trading

07/31/2014 8:00 am EST

Focus: OPTIONS

Bob Lang

Founder and Chief Analyst, Explosive Options

Bob Lang of ExplosiveOptions.net defines what he calls the guacamole dilemma, which poses the question, “Is too much of a good thing really that good?”

In options trading, there is something that I call the guacamole dilemma. It centers around whether too much of a good thing is really that good. When the markets drop 2-3%, which we have seen can happen within a week’s time, is it a good time to buy that dip?

If you look at the chart below, which dates back a year, the answer is a resounding yes—as long as we are talking about drops or corrections in price and not in time. What makes many options traders uncomfortable are the sharp drops that happen quickly over a few days (rather than a few weeks). We could blame that speed on any old reason—algorithmic traders, high frequency trading, hedgers, ETFs, or just a more informed and reactionary trader. Whatever the reason, we should look for patterns and trends that play out regularly, find confidence in them, and go with the flow.

This brings us back to the guacamole dilemma: How should we interpret drops and determine whether or not it is appropriate to step in?

I have found over the past year plus that these dips tend to be accompanied by very sharp changes in sentiment:

  • We’ll see a VIX spike (like on July 17) and a reversal, one of many that has occurred since 2012.
  • The McClellan Oscillator will show an extreme reading, with the Nasdaq and NYSE oscillators ticking down under -100 (very oversold).
  • Puts/calls often zoom past 1.
  • Polls show fewer bulls.
  • Traders get more fearful (just look at the AAII and II).

When the above line up congruently, I have found that it is a great time for dip buyers to jump in and buy that dip.

But…each dip could be the last one, faking everyone out, right? Sure, but that is not likely to happen right now when we have so much liquidity in this market, low interest rates, and strong corporate profits, not to mention a very dovish Fed that will continue to provide accommodation. I side with recent history.

chart
Click to Enlarge

Money moves very fast in this market, and if you’re not positioned right you can be trampled. Discipline trumps conviction in most cases, and we must be willing to take profits and losses and move on. As option traders, we do not have the luxury of time if we are buyers. With low volatility in this market, it means options are priced cheaply, a great condition if the trend continues.

Keep in mind, though, that market trends are not necessarily stock trends. For instance, the markets were hammered last Friday, yet some stocks performed well. While we know Amazon (AMZN) was clobbered (it was down 10%), Baidu (BIDU) was up (nearly 13%). Freeport-McMoran (FCX) was up 1%, Apple (AAPL) was up .6%, and Netflix (NFLX) was down 1%. My point is this: We continue to live in a non-correlated market, which is a stock picker’s delight.

The best friend of a stock picker is usually the charts and technicals—and again, we circle back to the guacamole dilemma. Do we trust each dip and buy? Will the next dip take stocks down for that massive 10-20% correction that everyone expects?

Well, you can sit around and wait for that, and—much like a broken clock—you’ll be right some day, but, in the meantime, how much time will you waste waiting for it? Let the market tell you what to do! Currently, the market is consolidating recent gains. Heck, from February 1 to June 30, the SPX was up 12.7%—isn’t it entitled to a break? In July, the SPX is up a scant amount, the Dow Industrials and Nasdaq are up solidly, yet the Russell 2000 is down an ugly 5%.

What’s to come for August and September?  I won’t guess the move, but certainly buying dips has been the right play, and it will continue to be, until it’s not. At some point, the pattern changes, and when that happens, we may find ourselves out of guacamole.

By Bob Lang of ExplosiveOptions.net

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