Postcards from the florida republic
An independent and profitable state of mind.
In my world, momentum is a measurement of capital inflows and outflows in thousands of stocks. I take the measure, then boil it down to a simple red, yellow, or green.
We’re coming off the longest stretch of positive inflows and price gains for the S&P 500 and the Russell 2000 since late 2021. So, now is a great time to discuss some important rules for trading in negative momentum.
I use a variety of technical indicators to determine how money is moving — but none are more important than the Money Flow Index, the Relative Strength Index, the MACD and the ADX 14.
And when the colors change, all hell can break loose.
In the event, here are my six rules for negative or “red” momentum.
Rule No. 1: Cash Is Your Friend
I move to cash when momentum turns negative. I know that sounds crazy - sell everything? Well, I don’t sell everything in my retirement account. But my trading account? Yes, I move to heavy cash.
I’m out of long positions, and I position my cash for buying opportunities. Since I’m an active trader and investor, I focus on key technicals that allow me to snag new entry points. The move to negative momentum is very important as I protect as much capital on the balance sheet as possible. This is how I can buy for $1 and sell for $2 many times each year.
Rule No. 2: Don’t Sell Puts, Unless… (See Rule No. 6)
If I’m selling put spreads as an entry point, now is not the time for me to open new positions. If I previously sold cash-secured puts or put spreads, I went into it with the mindset that I was willing to buy the stock at a lower price. If I’m up on my current position, I take profits. If I’m down, it’s time to assess whether I want to sell spreads at an even lower price.
When momentum goes negative, selling can be indiscriminate. That means nothing is safe. The last thing I would want to do is have exposure to a $50 put when the downside potential for the stock is much lower.
Rule No. 3: Learn Implied Volatility Rank
One of the great rules that I learned from my time with tastytrade and Tom Sosnoff was how to know the difference between cheap options and expensive options. I use a tool on tastyworks called Implied Volatility Rank (IVR). This measures the implied volatility of a stock today compared to its IV during the previous 52 weeks of the year.
If a stock has an IVR of 25, its implied volatility is lower than the 75% of the trading days over the last year. If it’s at 80, that means it’s higher than 80% of the days in the last year. The general rule is that if IVR is under 25, it’s cheap to buy calls or puts. If it’s over 30, I might want to sell calls and puts. And if it’s really elevated, that’s the time for me to do exotic trades like iron condors. This can also tell me which stock to trade and how to trade it compared to other ideas.
Rule 4: Sell Credit Spreads During Negative Momentum
If a stock is expensive to short with a long put, there are other “options.” I can sell vertical call spreads on stocks with a high IVR and benefit if the stock trades sideways or declines in value. I’d be selling someone the right to purchase a stock from me at a higher price. If the stock price falls, the underlying call will fall as well, thereby reducing the value of the call spread.
I use a higher call on the trade to protect myself against any surprise upside on a stock — think a buyout or sudden momentum reversal.
Rule No. 5: Look for Oversold Levels on the SPY and IWM
Finally, the market tends to sell off fast and furious in negative momentum environments. From June 8, the SPDR S&P 500 ETF (SPY) went from overbought to oversold in about seven trading days. Following SPY’s move on the Relative Strength Index (RSI) to under 30, the market was oversold. Oddly enough, no one had the guts to buy stocks.
Want to know who purchased shares in oversold conditions and made a fortune? Robots.
Algorithms — which have no emotion or fear — scooped up stocks in deeply oversold conditions and kept buying for a month. The market’s momentum didn’t turn positive for a month — until July 18 — but low-volume buying produced terrific gains for investors.
Rule No. 6: Wait… And Sell Puts in Very Specific Conditions
Oversold territory is also a very good place to sell puts on stocks I want to own when we eventually reach the time of “peak fear.” If the RSI on a stock is at 25, and it’s a great blue-chip company, I use the high volatility and the fear to sell puts on a stock maybe 15% to 20% lower than its current level.
If the stock does fall to that point, I’ll have an absolute bargain. But if the stock does rebound from overbought, I can repurchase the option for less and pocket the difference.
With that, I’m ready for battle.
It’s time to trade momentum.
About the Author
Garrett Baldwin is a globally recognized research economist, financial writer, consultant, and political risk analyst with decades of trading experience and degrees in economics, cybersecurity, and business from Johns Hopkins, Purdue, Indiana University, and Northwestern.