Mastering Derivatives: How to identify price reversals

Previously in this column, we discussed why options are good for betting on price reversals. To recap, options have asymmetric pay-off, whereas futures have symmetric pay-off. As betting on price reversals can be risky, you should use options rather than futures for such trades. In this article, we discuss how to identify price reversals.

Bulls and Bears

Bulls need trading capital to move an underlying. By this, we mean that bulls must continually buy the underlying, creating demand that can drive the price up. Bears need shares if they want to sell their holdings or margin money if they want to short the underlying. Note that heavy supply of an underlying drives its price down.

While the above is true for the spot market, the derivatives market is not very different. Bulls and bears need money to post an initial margin and a mark-to-market margin to set up long or short positions in futures. For options, bulls and bears need initial trading capital to set up long positions and margin money to go short. That means both bulls and bears need extensive resources to trade derivatives. The point is that neither bulls nor the bears can continually move an underlying or its derivative in their preferred direction. This is because both groups are likely to exhaust their resources after a while.

A price reversal happens when bulls or bears are exhausted. So, if an underlying is trending up for a while and you find the bulls are exhausted, it could be an indication that the underlying could either pause its rally or move down, albeit temporarily. Likewise, if an underlying has been trending down for a while and the bears are exhausted, it is highly likely that the bulls may push the price up, albeit temporary.

Empirical evidence suggests that bulls and bears are typically exhausted if they win for seven consecutive trading days. It is important to understand this argument. In many instances, bulls and bears may not win for more than three to five consecutive days. In such cases, you may have to read other signals, if you want to set up a reversal trade.

But when bulls or bears win for seven consecutive days, you could place the underlying on your watchlist for a possible price reversal. Note that more the underlying moves consecutively in one direction, greater the chances of price reversal. Of course, an additional indicator is how the bulls or bears move the underlying. If you use candlestick charts, you must pay attention to the size of the body of the candle and its tails.

As an example, suppose the underlying has been trending up for nine consecutive days and breaks above a resistance level. It is possible that the bulls may be exhausted even though the price has broken a resistance level. One indicator is the volume at the break point (the ninth candle in this case). If volumes are heavy, it could be an indication that the bulls are exhausting their resources to push the price up. That could be a sign of reversal. So, when the price turns and trades below the previous day’s low, buying puts or shorting calls could be beneficial.

Read the signal

More the underlying moves consecutively in one direction, greater the chances of price reversal

Optional reading

Your choice between buying calls (puts) and shorting puts (calls) when the underlying moves up (down) depends on which position offers higher expected returns. Note that if the underlying is poised for a reversal after a downtrend, implied volatility of calls is likely to be lower than puts. Also note that long positions are set up to capture gains from delta. Vega could add to the gains if there is a volatility explosion. Short positions are set up to gain from time decay. A decrease in volatility benefits short positions as it accelerates time decay. You should be concerned about theta (negative) for long positions and gamma (negative) for short positions.

(The author offers training programmes for individuals to manage their personal investments)

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