How to Stop “Flying Blind” in the Options Market

By TradeSmith Research Team

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Keith Kaplan, CEO, TradeSmith Daily

We’re facing a pivotal moment in history – not just as investors, but as Americans and, frankly, as human beings.

  • Inflation is turning out to be a persistent problem, the degree of which we haven’t seen in half a century. That means you have to make higher returns to stay ahead of it and keep your wealth-building journey on track.
  • At the same time, high interest rates are making that much more difficult – as companies that would be great growth investments are now strapped for cash and suffering.
  • And the backdrop to all this is worsening conflict (and more of our taxpayer dollars) in the Middle East and Europe… a contentious presidential election, to say the least… and the advent of world-changing technologies like AI, which toes the line between inflicting great harm to civilization and unlocking incredible potential.

It’s not a buy-and-hold investor’s market anymore, like it was for much of the past 15 years. There’s too much risk and uncertainty to simply put our heads down and hope that the market just keeps climbing higher. 

That’s precisely why short-term options trading is part of my overall investment strategy, as I showed you a couple weeks back.

Until recently, it’s been a relatively small part – separate from my long-term investments and income-generating plays on those investments

But because of the changes we’re seeing today, we at TradeSmith believe learning to trade the market’s rapid-fire ups and downs is essential to surviving and thriving the rest of this decade and beyond.

Some of my colleagues have called this the “Age of Chaos,” and that’s a good name for it. Because it’s not just about what’s happening, it’s about how fast it’s all happening… and how quickly the internet allows information to spread and influence investors. 

Throw AI into the mix, where it’s increasingly difficult to tell real information from fake, and… yes, Age of Chaos suits this time perfectly.

So today, I’ll show you some of my favorite tools we’ve created for making educated, data-driven trades… come what may in this perilous time.

How TradeSmith Helps You Trade the Age of Chaos Smarter

When you’re buying a stock for the long term, all you need to decide is: “Do I think this stock will go up?”

You don’t necessarily need to know how much it’ll go up, or when, or how fast. It just has to not go down over the long term.

When you’re trading options in the short term, it’s completely different. You must have a really good idea of whether the stock’s going up or down, how fast that’ll happen, and when it’ll happen. If you don’t, you’re flying blind.

That’s where a lot of new options traders get stuck in the mud. You head over to the options chain and, if you don’t have a plan, you have no idea how to proceed.

Our core mission at TradeSmith is solving investors’ problems with software. However someone wants to trade, we want to help make it easier with our world-class algorithms and intuitive tools.

And when it comes to trading options, we have all your bases covered.

Trade the Short Term with Predictive Alpha

Let’s start with Predictive Alpha. It’s a special analysis tool based on our AI tool An-E, which tells you where a stock is likely headed in the next 21 days.

Take Starbucks (SBUX), for example, which has been pretty beaten up lately:

Right now, An-E forecasts SBUX’s price to be $74.70 by June 5, 2024, about 1.63% higher.

With that in mind, we could buy an at-the-money call option on SBUX expiring in a few weeks… and profit even more if the stock runs higher.

(With call options, you’re buying the right to buy a stock at a certain price by a certain date. If SBUX shares run higher from here, the ability to buy them at a lower price per share becomes more valuable. That’s why trading call options works well as a kind of “leveraged bet” on a stock’s move.)

But that’s not all Predictive Alpha can do. Let’s take a look at the Volatility Spectrum for SBUX, part of our Predictive Alpha Options software:

Using Predictive Alpha Options gives you an incredible edge in determining the best options strategy to use for any stock at any time. Its Volatility Spectrum feature analyzes the unique volatility picture of specific stocks, then checks it against the stock’s price action, to tell you which strategy to use.

The lower the score, the more likely you’re set to profit on a stock’s upside volatility – and vice versa. A higher score means downside volatility is likely. 

Right now, the score points to three strategies – buy/write covered calls, sell puts, and buy calls. Each of these are bullish strategies to take advantage of upward price action.

So there are two pieces of algorithmic evidence that tell us we should be bullish on SBUX for the short term. And of course, you could use that evidence to make an educated options trade.

But there’s plenty of other ways to slice and dice the data to find new opportunities.

Separate Cliché Fiction from Seasonal Facts

Take our Seasonality tool, part of Trade Cycles, which shows you how any asset has performed historically through specific time frames.

Want to know how stocks do during May of election years? That’s easy to find. In fact, here it is for the S&P 500. The dark blue line is the current price action, while the lighter, greenish-blue line is the average price in the past seven election years:

The Seasonality indicator above is showing the average performance of the S&P 500 ETF (SPY) during each of the past seven election years, going back to 1996. You can see that between May 10 and June 8, the S&P 500 actually bucks the “sell in May and go away” cliché and returns gains averaging 3.42%.

With this information, you can construct a short-term trade on the S&P 500 ETF (SPY) designed to pay out if this happens.

That’s a more broad-based trade idea. We might not get a huge move out of betting on the broad stock market during this time, but we can have a lot of conviction in that move because of the seasonal factors backing it up. And we can use options to juice that relatively small move into something much bigger.

A New TradeSmith Tool to Find Great Trades

Finally, I want to show you something new to TradeSmith. We call it Harmonic Convergence.

This is when three carefully selected factors come together to form a single high-conviction trade idea.

Those three factors are:

  1. Seasonality, which we just talked about.
  2. The Relative Strength Index, which shows whether stocks are generally overbought or oversold.
  3. And the Trade Cycles software, which takes a stock’s individual trading history and determines the short-term cycles so we can project when that stock will reach a Peak, then drop to a Valley.

We recently developed a simple-to-use screener that looks for stocks showing a “harmony” of these conditions. If a stock is in a bullish seasonality period, is oversold on the Relative Strength Index, and the cycles show it’s moving through a Valley phase, it flashes a “Bullish Harmonic Convergence” signal.

This signal represents a high-conviction trade setup to the upside.

It flashes Bearish signals, too – stocks with bearish seasonality, an overbought RSI, and has reached a Peak in its cycles.

Here’s one such bearish signal on shipping company Tidewater (TDW):

The chart above shows TDW is currently in a Peak cycle, has an overbought RSI of 72, and is entering a seasonally weak period where it returns an average of -7% with an accuracy rating of nearly 87%.

That’s a powerful signal… and we can use it to trade TDW to the downside, with a put option expiring in July. 

All of these ideas are testament to how TradeSmith has prepared you to be a more successful trader, no matter your goal.

Even if the next few years prove to be a volatile, go-nowhere market, you’ll have everything you need to make the most of those swings.

I urge any investor who wants to learn more about becoming a better trader to stay tuned to TradeSmith Daily. Every single day, we share valuable insights to help give you a leg up and point you to great offers on our software suite.

And as always, we’d love to know whether you think we do a good job of that. Write us at [email protected] with your thoughts and questions anytime.

All The Best,

Keith Kaplan
CEO, TradeSmith