At OptionsAnnex.com we always consider the risk associated with each trade using the Probability Model. As such, we determine our risk levels using several standard deviation (SD) levels (i.e., 1 SD, 1.5 SD, and 2 SD).
In this article we will explore the notion of buying into weakness (when the markets are moving down), and selling into strength (when the markets move up). This is contrary to popular opinion in which many traders will buy stocks showing strength, and sell stocks showing weakness (a typical trend following approach).
To determine if this notion is correct, a 5-year test was conducted by Tasty Trade for three underlyings: AAPL (Apple), BIDU (Baidu Inc.), AMZN (Amazon). Strength or weakness in each stock was determined within a 2-week period in which a 10% change in price had occurred (positive for strength; negative for weakness). When a 10% move occurred, several positions were initiated using a monthly option chain with around 45 DTE (days to expiration).
To test buying into weakness, the following positions were implemented: sell a naked Put at 69% OTM (out of the money; approximately 0.5 SD); sell a naked Put at 84% OTM (approximately 1 SD); sell a Put credit spread (for premium one-third the width of the strikes; approximately 0.5 SD); and buy a Long Put ATM (at the money), which represents selling into weakness.
To test selling into strength, the following strategies were implemented: sell a naked Call at 69% OTM (out of the money; approximately 0.5 SD); sell a naked Call at 84% OTM (approximately 1 SD); sell a Call credit spread (for premium one-third the width of the strikes; approximately 0.5 SD); and buy a Long Call ATM (at the money), which represents buying into strength.
The Results (see Table above)
For AAPL buying into weakness: $5,122 (69%); $4,154 (84%); $854 (69% spread); -$3,675 (long Put)
For AAPL selling into strength: $2,455 (69%); $11 (84%); $635 (69% spread); -$5,580 (long Call)
For BIDU buying into weakness: $5,346 (69%); $3,594 (84%); $734 (69% spread); -$4,442 (long Put)
For BIDU selling into strength: -$1,376 (69%); -$205 (84%); -$1,371 (69% spread); -$3,632 (long Call)
For AMZN selling into strength: $5,085 (69%); $3,722 (84%); $209 (69% spread); -$5,107 (long Call)
For AMZN buying into weakness: $5,416 (69%); $2,275 (84%); $1,025 (69% spread); -$3,695 (long Put)
First, at no time did buying into strength or selling into weakness work; all Long positions (Put and Call) lost money. Even though we were ATM when entering these positions, indicating a POP (probability of profit) of 50%, the highest percent of winners was only 34%.
Second, buying into weakness worked for all three stocks at both levels of risk (69% and 84%). One advantage of this strategy is that IV increases as prices fall, and this helps to increase both premium and the position of the short strike (moving further OTM). The percent of winners far exceeded the expected probability for all stocks with naked Puts, and was at or exceeded expectations for the Put credit spread. The lower value for the Put credit spread is simply due to the 1-strike spread between the short and long strikes; had the spread been larger (around 5-strikes), the profit and percent winners would likely be equivalent to the naked Put at 84% OTM.
And third, selling into strength worked for two of the three stocks (the exception being BIDU) with percent winners at or above expectations; the notable exception, BIDU, is an indication of how difficult it is to trade this stock. BIDU, being very volatile in the short term, is not a stock you would want to trade with Monthly options; I would suggest using the Weekly option when selling into strength. Another issue with selling into strength is that IV would be dropping, which would lower premiums and move the short strikes closer to ATM; both of which actually increases risk over time.
In conclusion, the notion of buying into weakness and selling into strength works, while buying into strength and selling into weakness (following the anticipated trend) does not work. When selling into strength, you will likely do better short-term using a Weekly as opposed to a Monthly. In addition, the percent winners for the short positions were at or greater than what was expected (except for BIDU when selling into strength), indicating that the Probability Model is valid.
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