Two Ways to Play a Correction: Time & Price

Posted On January 23, 2017 2:18 pm

After the initial explosive rally following the election, the major indices and many individual stocks have been trading sideways within a narrow range. This has frustrated many investors who are patiently waiting to buy a dip.

For those who bought options thinking the market was about to embark a Trump induced increase in market volatility this period of probably led to losses as the dual headwinds of a decline in implied volatility and time decay is eroding premiums.

For all involved it’s important to note we may not get the dip we want or expect, as markets can also correct through time as well as price. For option traders it is important to distinguish between the two so you can apply the appropriate strategy.

Choosing Price vs. Time

Price and time are intertwining variables that must be controlled to obtain the profit envisioned in the trade setup, price pattern or fundamental observation that triggers market exposure. While many traders get half of this equation right, acquiring the skills needed to master both elements can supercharge returns, allowing perfect entries that translate into immediate profits.

A security will often generate a perfect price to open a position if you wait long enough. For example, a trader wants to take exposure in a strong uptrend but decides to wait until a correction drops price into a major support level. This buy the dips strategy requires patience but the position often turns on a dime after entry, resuming the uptrend because it was purchased at an ideal price.

Now consider a complex correction, in which the security spirals into a support level and bounces along its boundaries for a few weeks, building a basing pattern before reversing and heading higher. In this scenario, the perfect price may have been struck quickly but the position doesn’t reward the trader with a quick profit because the perfect time to enter doesn’t come until the security transitions out of the base and into the bounce.

Successful careers can be built using either methodology but the two variables require different psychological perspectives. Buying at the perfect price and not getting rewarded immediately can trigger doubts and paranoia that translate into stomach aches and premature exits. Meanwhile, buying at the perfect time forces the trader to sit out price action that’s attracting other participants, triggering fears of missing out on the opportunity.

It makes sense to build both skill sets while identifying scenarios that work with each strategy. Ideal price and time rarely align perfectly, forcing us to choose a path and then work through the psychological and mathematical headwinds. Perfect timing in particular requires a constant watch on price action, often draining energy that can be put to work with other opportunities. Get up to walk the dog at the wrong time and you could come back to a missed trade!

The two approaches create different average win vs. loss profiles. Buying the perfect price ensures smaller losses but takes a longer time for the greater profit potential to translate into realized gains. Buying the perfect time lowers profit potential and increases average loss size but the gain is booked more quickly, allowing the trader to apply capital other position. That approach also requires looser stops that contribute to higher average losses.

Of course, neither of these approaches guarantees an eventual profit. A security bought at a perfect price can lose money because the technicals identifying that level can be broken, yielding another high odds entry price. Meanwhile, a security bought at the perfect time may just chop sideways, going nowhere after entry, or roll over forcing the loser stop to get hit.

In the coming weeks as you look to add names to your portfolio or entry prices for trades consider periods of consolidation as two forms correction.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.