Going Parabolic

It is a rare occurrence to see an entire asset class in a parabolic move to the upside.

This particular and peculiar pandemic environment currently triggers at least two major melt-ups simultaneously: precious metals and technology stocks.

Gold and Nasdaq went straight up after their March 2020 lows.

The sheer range of the current price moves contains great opportunities – as well as great risk. By its very nature a parabolic move is incredibly difficult to anticipate. Bubble tops are notoriously hard to predict and trying to time them is practically futile.

So, how can we best take advantage of such an exceptional situation and trade it profitably?

As we rarely happen to be in the fortunate situation to be in on the move from the beginning, we usually need to find a way to participate once it’s already getting obvious to anyone. Of course we can employ thorough analysis, that makes it more likely to notice the developing potential early on. The same ideas apply then and are simply much more profitable, if the lift off occurs. The trade-off usually is that the earlier we try to identify an opportunity the higher the probability that the melt-up never materializes.

In my weekly report I find high conviction opportunities for my subscribers by combining an analysis of strong fundamental drivers, mounting speculative fever, a favorable technical situation and cross asset analysis. This worked very well for trading the recent explosion in the Silver ETF SLV from the top of a multi-year base at $18 to its current high near $27 – a parabolic breakout that is ongoing and still well suited to apply the following approach:

The good news is that, on an asset class level (in contrast to individual securities which are often “one hit wonders“), real parabolic bull markets often last longer than anyone imagines and there is usually plenty of time to participate.

Participating in a parabolic asset class rise

When a parabolic move lasts longer than investors think is possible each correction can be a lucrative entry point until the bubble deflates after a final blowoff. The telltale sign for this final top often is that there is no-one left to imagine the rise can ever end.

Asset classes and individual tech names in different stages of a parabolic move. The Nasdaq’s rise looks positively tame in this comparison spanning the past two months.

To avoid being caught on the downside, that often plays out as quick and violent as the upside, I prefer to trade such opportunities with call options. I simply define my risk through the cost of the option: if I happen to enter near the final breakdown I anticipate to lose my entire investment and size my position accordingly. On the other hand the likely case that the strong move will continue after a consolidation period will easily cause option prices to gain several hundred percent – especially in an asset class like precious metals where volatility jumps when price rips higher and further boosts option prices.

Entering in a correction

The key is not to overpay for the call options and the best place for an entry is a quiet period in a larger correction lasting about 1-4 weeks. Option demand, implied volatility and therefore option prices drop sharply. I enter in several partial positions in long-term OTM options using strong support areas and key moving averages (e.g. 20- to 60-day MA) as well as an apparent breakout after the bottom to build a full position over the course of several days to weeks. I define my maximum trade risk by expecting the options to expire worthless should my trade idea turn out to be wrong.

A chart from the last great Silver bull market that culminated in a parabolic blowoff top in 2011.

My current hypothesis is, that we are in the middle of a new, similar precious metal bull market that is still ongoing. The blue area in the chart shows a first parabolic move for Silver in 2010 (incidentally at virtually identical prices as we saw during the last weeks) forming a double top and then correcting to the 60-day MA for about one month before the final leg up begins (yellow circle). We could be near a similar intermediate top right now and, without trying to predict the exact top nor the time-frame, once we see a month long consolidation we have a very favorable entry point.

Overpriced options, on the other hand, will increase risk immensely and it is prudent to always take a close look at the potential reward : risk when entering a position. This brings us to the idea of using elevated option premia to our advantage by taking the other side – which works best with individual “one hit wonders“.

Trading individual securities

In my previous article Trading Parabolic Moves (…after the fact), I laid out some ideas for a systematic trading approach when we see overpriced options in an individual security. This particular trading model doesn’t even try to jump onto the moving train, but capitalizes on the tendency of a very extreme move to mean-revert or at least to calm down – resulting in deflating option prices.

A recent example for how this idea regularly plays out was the rise and fall of electric truck company Nikola right after its IPO.

A low float due to the lock up period after an IPO often leads to high borrow fees for shorting such a stock – this cost flows through to cause elevated option premia. When demand for options and shares to borrow shoots up together with implied volatility in a parabolic move, options often become extremely expensive. Selling them for their temporarily bloated premia is often lucrative as their price tends to collapse rapidly.

In this particular example it led to a premium of over 50% for an OTM put option.

A Twitter Thread highlights how the buyer of an overpriced option can easily find himself in a real jam:

“I bought Jan ‘21 70 strike puts on NKLA for $45 a contract when the stock was trading at $80. The stock has melted down to $30, as anticipated. But the puts have lost value. How can that be?“

Nikola stock shot up after its IPO, then calmed down and lost value in the ensuing weeks. Both short put and short call option positions would have been highly profitable, because their premia were highly inflated – giving the option seller a considerable margin of safety.

The easy answer to the question posed on Twitter: the put was crazily expensive (as were the calls at the same time) driven by demand, borrow costs and volatility. Only NKLA prices below $25 at expiration date would begin to yield a profit at a truly massive loss for the stock. Furthermore the profit would max out at $25 in the unlikely scenario that NKLA goes to zero – a really bad proposition when contrasted with a potential $45 loss.

Taking the other side has a very high probability for success with a great margin of safety in this case.

Good luck in your trading!

David