Consolidation and Breakouts
Well, it was a short, and rather disappointing, week last week. But not unexpected; a period of consolidation would be ‘normal’ market behavior. How long it will last is, of course, not certain.
What is Consolidation?
Consolidation simply means that it is a time period when a stock or ETF’s price moves within a narrow range, usually after a sharp uptrend or downtrend. In other words it ‘consolidates’ at that level before moving up or down. On a chart, it looks as though the price is going sideways, bouncing off resistance and support. An excellent example was SPY earlier this year:
During consolidation, traders are watching for prices to either breakout (go through resistance) or breakdown (fall through support). Breakouts signal that an uptrend is likely to continue, and breakdowns signal that a downtrend is likely. So, of course, consolidation periods are watched very closely.
Consolidation and Darvas Boxes
I have mentioned the Darvas Box in previous blog posts. Nicholas Darvas was a ballroom dancer who also followed the stock market. He noticed that stock prices tended to ‘bounce around’ in a ‘box’ before moving up, then bouncing around in another ‘box’ before breaking out again. He based his trading strategy on this, buying when a stock broke out of the top of the box (resistance), and placing a stop loss just below the bottom of the box (support). He is well known for turning a $10K investment into $2 million, in a short period of time in the 1950s, and he wrote a book about it.
It is a fascinating read. The thing that struck me most was that he was travelling all over the world, giving dancing displays, and so had no access to information. He relied on a daily telegram which contained the open / high / low of the stocks he was following. He had to do the graphs and boxes himself, of course, there were no computers in those days.
I particularly liked his observation that relying on cables forced him to concentrate on the price of his stocks rather what people said about them:
It was like a poker game where I couldn’t hear the betting, but I could see all the cards.
Which corresponds to the warnings I give in my books – don’t listen to what people say, watch what they do. And we are lucky that in the stock market we have a full record of what they actually do.
Throwing away what works
Darvas returned to America as a very rich man and started trading on Wall Street. Not a happy experience, losing $100K in a few weeks. In his words:
My trading at this time reads like a lunatic’s chronicle . . it was not the market that beat me, it was my own unreasoning instincts and uncontrolled emotions.
Sound familiar? It’s something we all have to watch out for if we are playing this game, and it is the hardest part of the whole thing!
Where it worked!
See the Daytrading Experiment below for an example of where it worked very well!
SPY Chart
The good news is that support at $444 is holding, so far, which is a good sign. More worrying is the bounce off the uptrend line. As we’ve noted before resistance lines often become support lines after a breakout, and support lines often become resistance after a breakdown. This also works with uptrend and downtrend lines, and you can see an example here. On the 1st September, SPY bounced off the uptrend line on the downside – i.e. treating it as resistance.
Does that mean that the direction is changing? Not necessarily. You can see that it could still bounce off the uptrend and keep going up. As usual, we can’t predict the future, but we can, like Darvas, watch what is happening and what is likely to happen based on how SPY has behaved in the past.
SPYG Chart
SPYG also came down last week, after touching a previous high ($63). Is that likely to become resistance? It is probable. There has been no breakdown below support at $61 which is good, but just like SPY it has bounced off the underside of the uptrend line.
As for SPY, it is watching and waiting to see what happens next.
QQQ Chart
Unlike SPY and SPYG, QQQ has not broken its uptrend – in fact it has bounced off it, in mid-August. That’s the good news. The bad news is that it has not yet reached its high of early July, and has basically been going sideways since early June, which is disappointing. However, we have to keep that in the context of its major rise since the start of the year. Support around $370 is holding. Again, we have to watch and wait. Not much fun, I know!
VIX Chart
The VIX has ticked up, but it is marginal – still well below 20, so technically we are in a low-volatility market.
Daytrading Experiment
Well, I see that I am up 5% this week (Woohoo! Not), and it was actually a bit of a fluke. I am only trading the DAX, and on Friday He (Tom Hougaard) was up 21 points (around $30 for me, not much at all).
I hadn’t managed to enter at his levels, and lagged getting out of some positions so I had doubled up – never a good idea. I was down to $4,208 when he signed off for the day. I was just thinking to myself this is not fun, and I’m losing money – I know its not much, but it is depressing. When I noticed what was happening on the 5 minute chart.
Yes – a Darvas box! Which was on support line from 25th August on the 1 hour chart. So – against my rules, which are to only trade what he said – I got in, and rode a nice uptrend before getting out (see the chart) I was so chuffed at this turnaround, that when it back rallied to this level I got in again, and rode it , getting out at the high of the day. Nice. Pity I was only trading small!
And I’ve included the statement with the transactions above – I’m very sensitive to people claiming that I am making up the stories!
ITMeter
More Holidays!
Next week I will be unable to post the blog on Monday (on holidays again!) If there are any actions to be taken, I will post on Tuesday, otherwise the next blog will be on 25th September.
This week . .
Well, at time of writing the futures are up, so lets hope for a good week. And in case you are wondering about the strange bull at the top – I was doing the charts on photoshop when they were advertising some new features – and the image they used was that bull. So, I snapshotted it, let’s hope it is a forecast!
Heather
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23 Responses
safe on the sidelines and this bear is angry
We’re a bit off the bear market, not yet in a correction – maybe you will be proved right, but let’s hope not!
I am looking forward to reading your future blog posts. Keep up the good work.
Thank you! I love hearing that people find them useful.
h
I have recently found your blog and want to become acquainted. The question is should I buy your first book before getting your last one. I believe in Timing the Market but is there any benefit n reading your first ITM book before getting your latest book. Sorry if this question has been answered before. Thanks.
Hi Tommy
Timing the market is a general book for people who buy stocks shoeing them an easy way to time the market and avoid bear markets, whereas In The Money: Bull Market Strategy is a book about an option strategy that beats the market.
Both are suitable for beginners, and it doesn’t really matter in which order you read them.
Timing the market is a short read, and In The Money is a full sized book that takes you right from the basics of options through to actually trading the strategy.
Hope this helps.
h
Hi Heather! I just finished your ITM Bull Strategy book and I must say it is a complete game changer. My question, however, is I am still very confused on how this strategy can ever lose. For instance, say SPY is at $400 and I buy a $200 DTIM call option. As long as price stays above my strike, I will make money on that option correct? Wouldn’t it be if price drops below my strike is the only way I will lose money? Maybe I am missing something here so I would love your guidance on this. Thanks and bunch and I will continue to read the blog posts. Hope to hear from you soon.
Ron
Hi Ron,
Technically you are correct, as in any option that expires above its strike price has to be worth something – e.g. if SPY dropped to $205 (Horrors!!!) then your option with a strike of $200 would only be worth $5.
BUT – what uyou are missing is what you PAY for the option. If you bought a $200 strike option for $220 then if SPY dropped to $205 then you would lose $215 (the cost of the options ($220) – the value of the option now ($5)).
Does that make sense? If not please get back to me.
h
Heather,
“SPX” European-style settled options are available from my broker, TD Ameritrade. I have been trading them for ~5 years. I’m in the USA where SPX options are treated as section 1256 contracts which affords me two unique advantages: 60/40 taxation (long-term rate/short-term rate) plus the wash sale rule does not apply to them. Given that these “SPX” options are available to me, do you have any objections to using them?
~ Mark
Hi Mark,
European options have quite a different price movement from American options, so I don’t know how the ITM Strategy would work on that.
I guess if you are holding to near-expiry then it should be OK – but if we get an OUT signal you may have to sell at less than face value. I’m trying to remember everything I know about them – I traded Eurostoxx and AEX for several years, and the pricing used to annoy me, as often if I could have exercised I would have been way in front, but I could only sell the option at the current market price. Ive been holding both Eurostoxx and AEX for some years – (in 2017 I got options 7 years to expiry, so they are valid until 2024 – Saxo changed the rules after that now you can only go 2 years out)
In short, I don’t know how ITM is going to go on European-style options – sorry!
(From Mark)
Quick question: Why don’t you use SPX options for ITM strategies?
Hi Mark
SPX is an index, and doesn’t have options. SPY is an ETF that mirrors SPX, and it has options.
It is explained in Chapter 5 of the Bull book.
Hope this helps.
h
(From Darren)
On September 14 at 5:30 am I was able to find the following prices to purchase SPY contracts on TD Ameritrade’s Think or Swim SPY price: 448.15, contract expiry September 20, 2024 (372 days):
Strike. Effective Price
225. 454
220. 453.9
215. 453.5
210. 453.2
195. 452.2
160. 449.99
Are others here finding the same results? I will be curious about what you think regarding the potential returns/losses with these effective prices. It seems that the increased premium reduces the leverage mentioned in the system. I am a newbie and just completed the Bull strategy book and am itchy to setup up my first DITM trade but am wondering whether this is a good time to do this? Is any time above the Golden Cross a green light to enter a DITM trade on the SPY? In other blogs on this sight, there has been mention of the SPY possibly falling during this time of year. Should one wait for the dip? Or just go for it as long as we are above the Golden Cross?
Darren
Hi Heather,
I’m wondering if you can sort something out for me. I bought “In The Money Compare Option Strategies” and on page 37 concerning Death and Gold Crosses you mention that they involve the 50 and 200 days crossing. However, in “Timing the Market” on pages 54 and 55 you say it’s the 10 and 200. I might be missing something, but could you help me out?
Thanks.
Kevin
Hi Kevin,
the ITM strategy uses the 10/200 SMA cross. In ‘Timing the Market’ I wanted to use a less sensitive strategy that also worked for the ETF stocks, not options, so I used the 50/200 SMA cross. It was really to show that timing the market was possible, using ETF stocks and without having to do more trades than necessary.
So – ITM definitely uses the 10/200 SMA cross and DITM options – Timing the Market uses the 50/200 SMA cross on SPY stocks, which is less sensitive and does not give such good results.
Hope this clears things up? If not please get back to me.
h
(From Michael)
VTI is exactly half the price of SPY and offers options to Jan 2025.
VTI returns are very close to SPY.
Might be a good alternative to SPYG that only offers six months out options.
https://www.etf.com/etfanalytics/etf-comparison/SPY-vs-VTI
Hi Michael
the difference between SPY and VTI is that SPY is based on the S&P 500, whereas the VTI is the total market, based on CRSP US Total Market Index, which is a broader spectrum of U.S. stocks. as it includes small-cap and mid-cap stocks. I have charted them both and they shadow each otehr quite well, there is a good options market.
The spreads are not too bad – 1.5%, a bit more than SPYG options, but not hugely.
I backtested ITM on SPYG and it worked – I think it would probably work on VTI also, so if you backtes please let us know the results!
thanks
h
(From Michael)
10/200 sma is good for entrees, but horrible for exits.
Drawdowns almost as bad as buy and hold.
Minervini and Weinstein both use 50 sma for exits.
10 sma would be a good filter.
Yes, might be whipsaws, but better than giving up most the upside.
Hi Michael,
I would have to back test using the 50 SMA before I could comment – and right at the moment I am backtested out! My initial reaction is that It was one of the strategies I tested, and it was too sensitive – whipping us out only to have to get back in.
But, you can check – here’s the blog post that outlines the steps you have to take: https://heathercullen.com/waves-or-tide/
I get that drawdowns are not pleasand, and should be avoided if possible – but we have to balance that with getting outwhen we don’t have to, and having to buy back at a higher price.
To me the test is not searching for the absolute best strategy – there are millions of permutations we could think of, you could spend your entire life searching! I was looking for an easy, commonsense approach that backtesting proved worked over the long term.
If you do the back test please post here and let us know the results!
Thanks
h
I think that if you Google it, you “bull” at the top is actually an American Bison (sometimes also called a buffalo).
Vern Tallman
Oooops!
Oh, well, it was a good day yesterday anyway, even if I got my animals wrong.
h
You are both right. Male bison are called bulls and the females are cows, just like cattle. And they are both bovines. Male bears are boars and the females are sows, but strangely, bears are not related to pigs. Go figure! 😛
My sincerest thanks for your excellent books and blog posts Heather!
Rodney
Florida, USA
Thank you Rodney!
h