Dear Reader!
As third quarter earnings kicks into full swing ahead of the holidays, we’re going to see a much greater focus on retailers and bankers in the near future.
And, the software I’m using, called Brutus, is identifying patterns in option volatility that we’ll be exploiting to make successful trades throughout the coming weeks.
In life, we’ll find a variety of patterns that can be used to provide a clear basis for solving problems and identifying opportunities.
You might even say identifying patterns is a critical thinking approach to recognizing broad-based opportunities and then shoring them down to individual opportunities, including option trading.
As we recognize patterns, we can build models of potential outcomes and anticipate what may happen in the future.
Patterns Are All Around Us – In Life, The Weather, Politics and Even Trading.
Patterns in human behavior, activities, beliefs and motivations are used to predict population growth in various regions.
A meteorologist may utilize patterns found in the weather to predict what the temperatures might be in different parts of the world.
If you look at the left image, you can get a real sense of what the temperature range will be in any given month throughout the year, simply by the patterns that past temperatures have created.
The stock market is no exception to creating patterns.
We can simply look over the course of time to identify patterns that are created in the stock market – and there seems to be an unlimited supply of them.
Traders are interested in stock market patterns as a means of enhancing their success rate.
And one such stock market pattern is the presidential election cycle.
(Mid-Term Election Returns – October, November and December)
For nearly 30 years, the months of the last quarter in mid-term election years have yielded positive returns 71% of the time.
With those odds, you can be sure bullish trading strategies can be a great way to make money during the fourth quarter of mid-term elections.
I’ve got some software, I call Brutus, that has found a pattern that occurs nearly 100% of the time on popular stocks – I’m talking about rising implied volatility (IV) ahead of earnings.
The Pattern of Implied Volatility Is Critical in Option Trading
The most frequent mistake I see most traders make is NOT paying attention to IV – and too much money is lost because of it.
Let’s break it down like this…
Options are priced according to three variables: days to expiration, strikes in or out of the money, and IV.
Time value will always take a huge toll on options. If we’re getting closer and closer to expiration and the strike prices is still just as far from the actual stock price as it was when you bought, the odds of success become less and less.
There is a weapon to combat deteriorating time value – Implied Volatility!
When demand for option rises, implied volatility kicks in to inflate premiums, which can help offset time erosion – and it can bolster the option’s market value when the security is moving in the desired direction as well.
Patterns of rising implied volatility ahead of earnings can be better visualized in charts.
Brutus has found nearly 130 stocks that have rising volatility potential this week and the Netflix (NFLX) chart below is just one example of the implied volatility pattern.
(NFLX – IV Spikes Ahead of Earnings)
On the left side of the chart above you can identify a pattern of rising implied volatility before the earnings were announced this past July by the red line – which is a boon to option premiums.
Take a close look, however, at what happens to IV immediately after an earnings report – this illustrates option premiums getting hammered by deflating implied volatility.
As you look at the right side of the chart, the red line depicts IV rising again, and you guessed it… IV is rising again just before Netflix reports.
Pattern Trading Is Reliable
There are so many patterns in life, but it’s market patterns that get me excited about trading.
A single pattern like rising IV is not the only thing I use in my decision making, but as you can tell from the graph above, predictable and reliable patterns are certainly worth my attention.
Once you recognize the value that market patterns create in your trading, you’ll be very surprised how they can positively boost your trading results.
Until next time,
Tom Gentile
America’s #1 Pattern Trader
Join Tom each Monday through Wednesday at 12:00 p.m. ET as he discusses a range of strategies to make money in a strained market environment.
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