3 Trading Strategies for a Choppy Market
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After the market bottomed in March 2020, you could throw a dart at any stock, buy it, and make money.
Then we moved to a phase where you just needed to hold Big Tech names.
Now we’re in a stock market desert — a place where folks wander, thirsty to find some oasis of profits. It’s not easy. But it doesn’t have to be so hard, either.
In fact, I know three strategies that you can use to generate income in a sideways market.
1. Selling OptionsSideways markets play with our emotions. As they go up and down, you feel like they’re about to break the range, only to watch them reverse.
Inevitably, when you do try to get cute and sell at the top or buy the bottom, that’s when it finally breaks out.
We can use options strategies to take advantage of the range-bound moves and generate extra income.
For stocks that we already own, I like to use covered calls.
As a refresher, a covered call is where you sell one call option, typically out of the money, for every 100 shares of stock you own. This pays you a premium, the price of the option contract, that you get to keep no matter what. If the stock reaches expiration and stays below the strike price you selected, the option expires worthless and you walk away with that premium.
Using the Options Screener in TradeSmith Finance, I can toggle various filters on and off to come up with different trade ideas on stocks I own.
Here’s an example using Google (GOOG).
In the boxes above, I filtered for call options I could sell on Google. The parameters above are shown for naked calls. However, they give me the information I would need for a covered call as well.
As of this writing, Google is trading at $2,831.
Assuming I owned 100 shares of Google stock, if I sold the first option, the $3,130 call that expires on May 20, I would receive a credit of $2,880, or $28.80 per option contract.
The probability of profit (POP) shows there is a 55% chance that Google finishes below $3,130 by expiration, based on the current implied volatility.
If Google were range-bound, I could sell this option expecting Google to stay below the $3,130 strike by expiration and keep that $2,880 credit.
Should Google finish above $3,130, I still get to keep that $2,880 credit. However, I lose out on any upside gains beyond $3,130, as I would have to sell my 100 shares of the stock.
Ideally, I want to use this idea on stocks in my portfolio that aren’t as healthy in the short to medium term but that I believe in over the long term.
2. Find Stocks with Relative StrengthHave you ever noticed how there always seems to be one sector that is outperforming the market no matter what’s going on?
That’s what we call relative strength.
Sometimes it’s cannabis stocks. Sometimes it’s solar power. Sometimes it’s an industry you’ve never heard of.
However, TradeSmith Finance’s momentum tools can help you pick out equities and sectors that are doing better than the rest of the market.
Energy and technology stocks offer the perfect example.
With crude oil prices sizzling, energy stocks have experienced a tremendous renaissance.
But it’s come at the expense of technology names that can’t seem to catch a break.
In fact, some of the high fliers from the pandemic — Zoom Video Communications (ZM), Fastly (FSLY), and others — are down more than 50% from their highs.
Yet names like APA Corp. (APA), Occidental Petroleum Corp. (OXY), and Devon Energy Corp. (DVN) are at or near all-time highs and don’t appear to be letting off the gas (pun intended) anytime soon.
3. Trade the RangeEarlier, I alluded to a situation where you might try to “get cute” and sell the high of a range so you can buy it back lower.
This strategy can be used, just not haphazardly or indiscriminately. It needs to be focused and specific.
Here’s what I mean by that.
At TradeSmith, we talk a lot about momentum and how trends in stocks can keep it moving in a particular direction over time.
However, some stocks trade sideways for years at a time. Sharp moves higher or lower in these types of stocks can create an opportunity.
When we see a sharp move that sends a stock’s share price to the upper or lower end of a range, that’s when we can look to take a trade in the opposite direction.
If you own the stock, you can sell part of your position at the upper end of a range and/or buy it back at the lower end. This is what’s known as trading around a core position.
Conversely, you could sell options as we discussed earlier.
One way to track whether a stock is over- or underextended in one direction or another is the Bollinger Bands indicator.
Bollinger Bands look at a trailing period of the stock’s close, typically 20 to 21 periods (length of each “period” measured can vary), and calculate a specified number of standard deviations, usually two, above and below the current price.
Mathematically, the indicator says based on the inputs, the closing price for the stock should land between the upper and lower boundary 95% of the time for two standard deviations (99.7% of the time for three standard deviations).
Here’s an example using IBM (IBM), which is notorious for not going anywhere over the last two decades.
The chart above measures the weekly move for IBM’s stock in each candlestick. Over the last few years, the share price rarely exceeds $145 on the upside, noted by the upper orange trendline, or $105 on the downside, noted by the lower orange trendline.
The light blue shaded area is the range defined by the Bollinger Bands indicator using two standard deviations looking back 20 periods.
What I want you to notice is that when IBM goes near the upper or lower trendline and the upper or lower Bollinger Bands, it often snaps back in the other direction. That’s where you can take a trade with the expectation that it will move back in the other direction.
Where would you be wrong? If the stock closed below the trendline for multiple weeks. In the chart above, that’s only happened once.
The point with all these strategies is that you don’t have to limit yourself when stocks are stuck in a range. You can simply adjust to the market conditions and keep an eye out for when they do change, because they always will.
So let me ask you: How are you preparing for a potential sideways market? What steps will you take to ensure you keep earning income?
Email me and let me know.
While I can’t answer your emails individually, I promise to read every one.