Recently I wrote an article on the concept of time. In today’s piece, I want to focus on a topic that also has to do with time. When identifying key turning points in markets, one question that often arises is the notion of “how far back to look for supply/demand levels on a chart.” Conventional wisdom says that the further back the level is, the less effective it is. As we know in trading, conventional wisdom is typically not just wrong, it’s often backwards.
Let’s take a look at a trading opportunity that came up last week that we identified in the Extended Learning Track (XLT, our live trading room). I also took advantage of this trade using Options. When predicting market turning points and market moves in advance, only one thing matters. Where are the institution buy and sell orders? We use our Odds Enhancers and look left to find the picture that represents these buy and sell orders. Last week, the Dow was making new highs, the NASDAQ and S&P were at levels not seen in quite some time as well. The NASDAQ however, while very high in price, was nearing a key supply level. Notice the QQQ below. The area shaded yellow represents this key supply zone where institutions and banks were willing sellers. Also notice the date of the level, it was created back in early October 2012.
After the initial decline in price from that level back in October of last year, price stayed below that level for many months. Last Tuesday, during our live trading session with our students, price rallied back to that level for the first time as you can see from the chart below. On our prep screen that always starts our sessions off, the plan was to sell short in the NASDAQ Futures if and when price rallied back to that supply level. During the session, price did rally back to our level, giving us the opportunity to sell to the buyer who was buying after a big rally in price and into that level where the chart told us, supply exceeded demand. Price turned quickly and proceeded to fall more than 20 NASDAQ points in a short period of time.
XLT Session (Live Trading and Analysis) – Tuesday April 2nd, 2013
Back to the main question and point of this piece. You may be wondering how a level from so far back can produce a turn like that so far in the future. Have banks and institutions been waiting with orders sitting this long? I am not suggesting its the same people with the same orders sitting for months and waiting. What I am strongly suggesting is that the chart does a perfect job of showing us price levels where supply and demand are extremely out of balance. So much that we can accurately decipher between retail and institution buying and selling. When we clearly see that institutions are heavy sellers at the same price level that retail is buying at, that is when it is time to take action and put our hard earned money on the line.
The simple play was to sell the NASDAQ futures short or the QQQ. What I did instead was take a position in Options. When price was trading back to the supply level, puts and calls were being bought and sold. If we focus on the calls for a moment, volatility was somewhat high, price was at a level where institutions were selling and retail was buying. The only question to consider when dealing with calls and puts at that moment is should you be the buyer or seller of the calls at that price. When you can identify these factors on a chart, clearly, you want to be the seller of those calls (institutions), not the buyer (retail). By doing a simple credit spread, I was able to take in premium of $2,560 for that trade. While the trade looks like I am risking between the strike sold and the strike bought, that’s only the risk on paper, I would never let it go that far. Had price rallied to just above the supply level, I would have exited the trade for a small loss.
The main point of this piece however is regarding time. Typically, the further back a level is, the better. I know that sounds backwards but think the logic through and you will understand why these work so well. If price is reaching a fresh demand or supply level from long ago, by definition price is far out on the supply/demand curve which means the odds are stacked in our favor. Whoever was on the other side of my trade was buying after a huge rally in price and right into a price level where supply greatly exceeded demand. And, this was all happening very high on the supply/demand curve for the S&P/NASDAQ.
Hope this was helpful, have a great day.