In physical futures markets every so often, supply, demand, and market sentiment among the participants become so unbalanced that prices becomebid to amazing levels. Usually, the bull move in such markets begins when the market participants realize the possibility of a supply shortage in future.Developments unfold and supply problems do begin to emerge, prompting users to begin to anticipate future needs in advance of their normal schedule,and also attracting speculative interest into this market.
At some point,in addition to whatever degree of supply shortage actually exists, some number of market participants also begin trading on a perceived worse shortage in future, and that’s when prices go wild. The daily price bar chart moves upward in a manner resembling the right-hand side of a parabola, margin requirements go to the moon, and people who have been caught short in this market begin thinking that the window ledge on the 35th floor looks mighty attractive.
As all this develops, you and I should be sharpening up our colored spears, because we’re about to be handed a whole lot of money. These runaway parabolic markets all end, typically in a few weeks or months, and they almost invariably give a very clear signal to the watchful trader as to when to help himself to other traders’ capital. We’ll just sit around and watch, laughing with the bulls and commiserating with the bears (assuming they haven’t availed themselves of a trip to the 35th floor yet).
By and by, and we simply don’t care how long it takes, the bull market is going to top out. We are distinctly not going to attempt to time this action,or to anticipate it; it’ll happen when it happens. The market will top out, begin heading lower, sometimes very sharply, and then, a little later, a couple of weeks or a month or two, the market will make a run at the old highs. If it makes new highs (rarely), we’ll continue to watch and wait.
If this secondary run-up fails, though, that’s it—that’s the end of the party, and it’s time for us to become picadores and start to carve up the dying bull.When exactly do we swing into action? We wait, specifically, for the third day down after the top of the secondary run-up. That’s all, nothing fancy, and anyone can play. Furthermore, we discard the notion of statistical risk, and we park our pricing model in a desk drawer for a while, at least regarding this market.
There’s nothing at all normal or lognormal about price distribution under these conditions, and it will probably be quite some time before this tool will be useful again in this specific market.Carving Up the Bull—The Knife to Select:I maintain, and have for years, that a successful trader is generally a professional coward, and this sentiment is at its truest during and just after parabolic markets. Statistical risk calculations are meaningless in such markets, and we will opt for an absolute and measurable dollar risk here.
As far as I’m concerned, the single most cowardly way to slice up this kind of ailing bull is to apply a debit put spread, also called a bearish put spread. This is a structurally simple tactic that involves buying a put option, in this case having a strike moderately below the market, and selling exactly one other put, with a further OOM strike, that expires in the same month. All right, now how do we select an advantageous pair of puts for this spread? The first thing we’ll do is to stop looking at the nearby contract in our bull market.
It’s fun to watch, to be sure, but is definitely not the best place to make our profit. Once again, we must allow the other market participants some amount of time to fatten our wallets, and to this end we’ll want to look at the put options in a regular month 2 to 4 months away, or even further out if the premiums are encouraging. The further-out futures contract will usually be lower in price than the nearby month most of the time under these assumed bull market conditions, but if it isn’t, if instead it’s a little higher, that’s fine with us.
The put option we’ll buy will have a striking price typically 3–10% under the current market price of the month we’re watching. Which put we write will depend on our level of confidence in this strategy. I’m quite confident of its profitability, and I tend to write a put whose striking price is 3 or 4 strikes, even 5 strikes below the put I’ve bought.
If you’re less confident, then writing the put only 2 strikes below is a good compromise, because your capital commitment to the trade will be lower.Our trade begins at a debit, which I don’t much like (as you know very well by now), but its historical success is nothing short of astounding. I haven’t ever found a (former) parabolic bull market that met our not-veryrestrictive entry condition, where this strategy took more than 30-40 elapsed days to become profitable.