Option Strategies: How to Identify a Topping Market that is Prone to a Reversal
Option stratgies: often it is important to combine classical technical analysis with the basics of common option strategies. Most trading systems focus on what and when to buy. However, making the best buy decisions is not enough when it comes to profitable trading. A plan for taking profits, exiting losing positions and selling short is also necessary. The best time to exit a long position is when there are indications of a market top and probabilities of a trend reversal are high.
Given that most of a financial asset’s fundamental information has already been priced-in by market participants, the most effective way to trade is to respect the laws of supply and demand as represented by price and trading volume data and ignore fundamental analysis or personal views.
The following topping signals are especially valid after a market has had a long advance and is starting to lose momentum or reverse. They apply to all types of financial assets (stocks, currencies, commodities, indices) but they are more prone to be effective in option strategies. Let us go over the list of signals that a market has topped:
The most important piece of market information is price, which adjusts swiftly to changing market conditions and investor expectations. The following signals that a market is topping are easy to look for by traders and to be included in option strategies:
PRICE MARKS ITS LARGEST ONE-DAY DROP OF THE LAST WEEKS (or months).
THE NUMBER OF CONSECUTIVE DOWN DAYS IN EXCEEDS the number of consecutive up days. For example, you may see five days down followed by three days up in a weak market, whereas you may see five days up and three days down in a strong rising market.
EVEN THOUGH PRICE INITIALLY ADVANCED DURING THE DAY, IT finally retraced most of the advance and closed at or near the session’s low.
AFTER BREAKING DOWN FROM A PEAK, A MARKET NORMALLY rebounds for a recovery rally. If the duration of the price recovery is short or retraces only a small part of the losses, this signifies trouble for the market and lower prices ahead.
Technical Analysis Signals in option strategies
The trader can also use in option strategies classical technical analysis tools, such as trendlines, chart patterns and moving averages in order to identify weakening or topping markets.
In particular, a market is very vulnerable to a correction when:
4HE DAILY (OR WEEKLY) CLOSE IS below a significant support line, which connects at least 3 intraday price lows occurring over a number of weeks.
THERE IS A LOT OF OVERHEAD PRICE RESISTANCE THAT MAKES it more difficult for price to advance.
PRICE TEMPORARILY BREAKS PRICE RESISTANCE BUT CANNOT hold on to its gains and retreats. Unsuccessful attempts to push price through resistance signify that buyers are not strong enough to gain the upper hand in the market conclusively, and this often results to a trend reversal.
WELL-KNOWN BEARISH CHART PATTERNS, SUCH AS hHEAD & shoulders”, “double or triple tops”, “descending triangles”, “bearish flags”, “rising wedges” etc indicate a high probability of trend reversal
when confirmed, i.e. when their support line is broken. The longer it takes such patterns to develop and the larger their trading range, the more extensive their reliability and expected move.
THERE ARE *APANESE CANDLESTICK formations indicating high probability of a bearish reversal. These are known with names such as “Three Outside Down”, “Evening Doji Star”, “Dark Cloud Cover” etc.
PRICE FALLS BELOW A KEY MOVING average (MA), such as the 50-day or the 200-day MA.
FASTERv MOVING AVERAGE, SUCH as the 50-day MA, falls below a “slower” one, such as the 200- day MA.
THE SLOPE OF A KEY MOVING AVERAGE LINE HAS STARTED TO turn down.
THE MARKET IS UNDERPERFORMING COMPARED TO RELEVANT financial instruments, that means it is a laggard while other markets are doing better. Stock market traders compare relative strength* among members of the same industry group as well as against the general market index.
PRICE STRENGTH IS NOT CONFIRMED BY ANY OTHER comparable asset of the same group or by the market index. In other words, it is easier for a security to roll over when the general market is weak.
Climax Signals in Option Strategies
In many cases, after a long move up, the price advance gains traction in a dramatic and unsustainable way “climax top”. At this phase, investor optimism is excessive and prices run rampant. The day opens with an “exhaustion” gap up after it has extended greatly from its consolidation levels and basing pattern, as well from its “optimal” pivot buy point.
However, shortly after this price jump, market sentiment shows a sharp and sudden deterioration, causing a gap down in price and forming a “bearish island reversal” on the chart. The weekly price trading range (high to low distance) is the greatest of the last months.
Note that not all price gaps are exhaustion gaps. Also do not confuse a climax top, like the one described above, with a security advancing from a nice basing pattern and making new highs on big volume as this latter case often signifies a likely continuation of the uptrend.
Given the significance of institutional trading in today’s markets, an efficient way to identify such trading is through volume data, which are readily available. Pure price and technical analysis signals gain in significance when “confirmed” by volume. Traders need to compare the day’s volume to its moving average first, in order to get a better idea about its relative size. The most reliable volume-based hints that a market has topped are the following: Price is falling on heavy, above- average volume. Big volume on a down day implies that some important negative fundamental information hit the wires and institutional investors unloaded their large positions aggressively.
Price moves sideways even though trading volume is heavy. This shows that there are a lot of persistent sellers who limit the market’s upside price momentum. A topping market often shows such signs of “distribution” after a prolonged rally. During this market phase, informed investors (“smart money”) take advantage of high asset demand by latecomers to the market in order to scale back their positions.
Price marks a new high on low volume. This indicates that buying interest is limited and the price rally is suspect. When trading volume data show that institutional investors are either absent from a market or are active sellers, we conclude that they are not convinced about the price upside potential, which makes it much harder for this to advance because of the amount of capital these people control.
Conclusion in top reversal signals in option strategies
Final thoughts on topping markets, market trends and risk management. It is often difficult to spot a topping market in its early stages. Sometimes what looks like the beginning of a new downtrend is just a normal correction within an uptrend. In other cases, what looks like a normal correction within an uptrend might be the beginning of a new downtrend.
Always respect the prevailing trend. Trading decisions should be based on price action, which normally precedes significant fundamental changes. Look for price confirmation in other related markets. Avoid committing yourself to the short side before price and volume signify that a downtrend is in place. Avoid long positions in a market that has topped and sell the weakest portfolio components first.
Even when the trader identifies topping signals like the ones described in this article, there is no guarantee that the market will indeed reverse and roll-over. Traders, therefore, always need to use tested position sizing and stop-loss algorithms. Stop-loss orders on short positions can be trailed lower (trailing stops) so that the trader can stay with profitable downtrends longer. Finally, positions showing a nice profit should never be allowed to develop into a loss. «
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