We’ve witnessed an incredible move in the industrials since the onset of July.
At the open today, the SPDR Dow Jones Industrial Average ETF (NYSEArca: DIA), which tracks the Dow 30 stocks, was trading at $255.50. That’s a gain of almost 6.3% this month … or 18 trading days. A move that sharp over such a short time frame has led to an extreme overbought reading in DIA and several other major benchmark ETFs.
I don’t use the word “extreme” lightly. Often, particularly in the world of trading, the word extreme is thrown around with little to no context. As options sellers we need context; otherwise the information is useless. Again, that’s why I use the word “extreme” sparingly.
The image above shows the options chain for DIA at the close on June 29, the trading day before the industrials’ recent surge. The highlighted area in blue shows the July 255 strike. More specifically, it shows the Prob. ITM, or the probability that DIA would reach $255 by July 26.
In other words, as of the close on June 29 there was a 5.1% probability that DIA would move roughly $15 higher and hit $255 by July 26.
We can also see the short-term extreme using my favorite mean-reversion indicator: RSI.
RSI, or relative strength index, was developed by technical analyst J. Welles Wilder Jr. It’s an overbought/oversold oscillator that compares the performance of an equity – in our case a highly liquid ETF – to itself over a period of time. It should not be confused with the term “relative strength,” which is the comparison of one entity’s performance to another.
Basically, the relative strength index allows us to gauge the probability of a short- to intermediate-term reversal. It does not tell us the exact entry or exit point, but it helps us to be aware that a reversal is on the horizon.
As an options trader, I love this scenario. It’s this type of scenario that has led to cumulative gains over 250% in 2018.
Extreme, short-term, overbought readings – like what we are currently witnessing in DIA and many of the major indexes – often lead to a reversion to the mean over the short term.
“Reversion to the mean” simply means that there is a greater chance of a short-term reprieve or “fade” in the price of the underlying stock. I like to think of it as the perfect opportunity to sell premium.
So, given all the information stated so far, I’m obviously bearish, at least over the short term. I expect to see sideways-to-lower price action over the short term. But, I want to increase the odds of my bearish stance, given the extreme in mean reversion, by using an options strategy that allows me to have a margin of error just in case the short-term extremes continue.
In this case, a bear call spread – or vertical call spread – is the options strategy of choice. It’s probably the most-used strategy in my arsenal of options selling tools, for a variety of reasons.
I’ll discuss those reasons in my webinar next Tuesday, July 31, at 12 noon EDT. In my discussion, I will not only explain my step-by-step approach to the options strategy but I will also go over several real-time trades. I hope to see you all there for what will certainly be an eye-opening event. Click here to reserve your seat.