There’s a reason markets get stuck in a range and then get violently pulled back into it, and it has nothing to do with technical analysis.
I call it the volatility box.
People hear the word range and immediately start drawing Fibonacci retracements all over it. I’m not going to sit here and prognosticate on a 618 or some crap like that.
Here’s what happens.
A market channels back and forth for a considerable period, weeks or months, and every single day inside that channel you’re accumulating more and more open interest at those strikes.
Think of it like a little tiny snowball that starts to grow, and it grows, until eventually there’s one mother snowball sitting inside that pocket.
Now, who’s on the other side of all that?
Market makers, and here’s what most people miss about them.
On every trade you do, whether you buy stock or sell stock, somebody is always on the other side. People miss that all the time.
And those counterparties have no skin in the game directionally. They don’t care where your stock goes. They never did.
Citadel’s market making unit doesn’t want directional risk. Jane Street makes money hand over fist and they don’t take directional risk either. Everything a market making firm does is tread water to make a tiny fraction of a penny and do it millions of times a day.
So they hedge everything, constantly, all day long.
As price grinds higher out of a range, they’re buying futures against all that open interest sitting underneath them, and they carry that risk on their back the whole way up.
Then price slips back into the range.
Now they have to unload every one of those futures contracts they bought on the way up. You think they’re selling because they turned bearish overnight? They’re balancing a book. That’s the whole reason and there is nothing else to it.
The snowball rolls up the hill, they have to buy. The snowball rolls down the hill, they have to sell.
That’s why the drop back into a range is usually faster and uglier than the climb out of it. You don’t even need new sellers to show up, okay? The hedging does it for you.
So here’s what to do with that, and you can apply it to any index or any heavily traded name.
Find where price has been chopping for months and mark the top and the bottom of it. Then watch what happens when it comes back inside after spending time outside.
The move back in is where the open interest lives, and the people who have to trade against it are not doing it because they want to.
Which is exactly why I stopped trying to guess direction years ago.
I want to know what the hedging has to do, not what I think the market ought to do, and I’ve hit 30% or better inside 30 days 44 times in the last 16 months working that way.
Thursday at noon Eastern I’m walking through the whole thing live, and somebody in that room is going home with $2,000.
To your success,
Don Kaufman
