Turning Scary Narratives Into Scary-Big Wins

By TradeSmith Research Team

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A couple weeks ago on Oct. 23, I said you should “hold your nose and buy” the iShares 20 Plus Year Treasury Bond ETF (TLT).

Back then, long-term Treasury yields were wreaking havoc on the stock market. The largest, most liquid, most systematically important financial institution in the world – long-term U.S. debt – was crashing to a 20-year low.

But, ever the contrarian, I was confident that the full-blown panic in the Treasury markets would come to at least a short-term end. So, I recommended an option trade to take advantage of the extreme volatility.

As I wrote at the time:

TLT December 29 $85 call option is trading for $2.42. Options trade in lots of 100 shares, so we’re talking about $242 per contract. And it gives you the right to buy TLT for $85 anytime before Dec. 29.

Let’s say TLT reverses higher and reaches its most recent peak at about $88.50 per share. Doing so by Halloween would result in a gain of about 124% on the option, for a profit of $300.

Even if it took until the end of November to see that move, it would still result in a gain of about 88%, or about $212 per contract

Here as I write on Friday, Nov. 3, it seems we got exactly what I was looking for – and sooner than I expected.

The FOMC meeting came and went without a rate hike. Jobs data came in cool, showing that unemployment ticked up to 3.9% and the U.S. added half as many jobs in October as it did in September. That’s finally showing that the Fed’s rate hikes are slowing the economy, and further hikes might not be necessary.

Long-term Treasurys seem to have met at least a short-term bottom. TLT is trading at $88.64, 5% higher from where I wrote you. And the TLT December 29 $85 call option is trading for $5.00 at writing, a profit of $258 per contract and more than a 100% gain.

If you took this trade, this is where I’d look to take profit. (And if you did, I’d really love to hear from you. Write me at [email protected].)

But don’t worry, I’m not writing this to simply beat my chest.

I’m writing this to help you understand how you can regularly use market panic to your advantage – and to share another idea of a scary narrative impacting an oversold sector, ripe for comeback.

Note the Signs of Panic – and Confirm

One effective method of trading the market is identifying extreme situations, and simply betting that what goes up, must come down, and vice versa.

Often, these situations begin with narratives. The narrative that led to TLT becoming deeply oversold was the fear of rate hikes weighing on the ability of the U.S. government to pay its debts. That narrative spiraled, and Treasurys sold off in extreme fashion.

But recognizing these narratives is not enough. You have to confirm the trade with the price action in the chart.

Here’s a fresh example.

Right now, the renewable energy trade is unraveling. Reports of poor-selling electric vehicles (EVs) and high capital costs weighing on green energy projects have the sector in crisis.

That’s the narrative. It’s an overwhelming, scary narrative. “What if we can’t afford the transition to green energy? All these companies are going down! Climate change will kill us all!”

An extreme narrative like that is ripe for a short-term reversal.

But let’s confirm that on the chart.

Here’s the Invesco Solar ETF (TAN), one of the most popular tickers representing green energy investments. It’s down nearly 40% this year:

Here, in TAN, we have a similar situation to what we saw in TLT. While the price is lower over the last couple of months, the Relative Strength Index (RSI) and Moving Average Convergence/Divergence (MACD) technical indicators are showing positive divergence (the white lines at the bottom of the chart). The sector is less oversold today than it was at higher prices two months ago.

We also just got a cross on my RSI signal line, and a bullish cross on the MACD signal line.

Could TAN go lower from here? Absolutely. I don’t have a crystal ball and neither does anyone else.

But if Treasurys have bottomed, the Fed is done hiking, and the market is going to participate in a broad-based rally to close out the year, as history shows, then it stands to reason that TAN and other speculative sectors like it should recover to close out the year stronger than where they are today.

You could buy TAN here, or buy an at-the-money call option expiring a few months out, as I suggested with TLT, to trade this chart.

But today’s essay is more about showing you how to turn these overwhelmingly negative narratives into trade opportunities.

Make no mistake, we’re in a new era. High interest rates and high inflation will be with us for some time to come.

But all that means is that there will be more of a “winners and losers” dynamic, along with a whole heck of a lot more volatility, than we saw in the last bull market. Not everything is going to go up at once. And there’ll be quite a few red days mixed in with the green.

So long as you make it a priority to get comfortable trading these moves, to the upside and downside, you’re likely to come out ahead.

To your health and wealth,

Michael Salvatore
Editor, TradeSmith Daily

P.S. The TradeSmith Analytics dashboard is what originally alerted me to TAN. It’s currently listed as the most oversold sector in the market. So this was a case of the technical informing me of a prevalent negative narrative surrounding the sector.

I really can’t recommend TradeSmith Analytics enough. It’s one of the best ways I’ve seen to quickly find strong trade ideas like this one. Check in with it often.

And I’d just like to say, I’d love to hear from anyone who traded that TLT recommendation. Write me at [email protected] with your results.