Because options are often purchased in panic, their prices swing wildly. When the market is rising, calls get extremely expensive. When the market is plummetting calls get dirt cheap. There are all kinds of valuation methods to determine whether options are expensive or cheap but they are far beyond the scope of this series. Generally, at market lows, calls are cheap and that is the opportunity we are seeking.
So, one key is obviously determining if we are at a market low. At market lows:
- The market has fallen significantly.
- There is a reason that the market is unlikely to fall anymore.
- There is a reason that the market should turn upward for a few days.
Has the Market Fallen Significantly (#1)?
There are many ways to determine whether this is true. We are looking to keep this simple. The simpliest method of determining whether this is true is by looking at the Dow Jones Industrial Average (DJIA) in relation to its 21-day moving average. The DJIA is the stock market index that is the most visible to the dumb money. This is why I like it so much. The DJIA is just 30 big companies stocks added up and divided by some number. Even though it's only 30 stocks, it represents the stock market very well.
The 21-day moving average (21DMA) is just the last 21 days' closing value of the DJIA added up and divided by 21. This 21DMA smooths out all the ups and downs in the DJIA.
Historically, the DJIA oscillates around its 21DMA and this is the key to giving us some of the information we need.
- If the DJIA is far above it's 21DMA, then it's "high".
- If the DJIA is far below it's 21DMA, then it's "low".
Historically, the DJIA is "low" when it is 3.5% below its 21DMA.
The graph above is the DJIA with three lines. The middle line is the 21DMA the lower line is the 21DMA minus 3.5%. As you can see, the DJIA often makes a significant low at the lower line which is "3.5% below the 21DMA". Therefore, when the DJIA is at the lower line, it has "fallen significantly" and #1 is true.
We still need a reason that "the market is unlikely to fall anymore" (#2 above). Therefore...