The Dow Jones Industrial Average (DIA) finally broke the 20,000 level after flirting with it for weeks. This has prompted plenty of mainstream news pieces on the development, both arguing for its importance and dismissing its value at all. A common theme is wondering whether the Dow Jones can actually maintain this level for long, and how underlying earnings trends will allow it to do so.
For institutional investors, the development mostly doesn’t matter. Most funds invest on a medium-term or long-term view of a company’s growth potential, current valuation, and market position. Short-term trends are mostly irrelevant to professional investors when they look at the future prospects of a company. However, short-term movements are not entirely ignored. When it comes to trading and execution, firms will employ a mixture of technical analysis, high-frequency trading technology, and complex algorithms to keep costs down and get stocks at the lowest price possible (and sell at the highest price possible). On this side of the business, resistance levels matter for two reasons.
Firstly, they matter because they can offer a prolonged buying window. If the Dow Jones average was being kept under 20k by underlying stocks staying mostly level for a couple of months, that extended the buying period for a fund to buy into stocks that they see as having strong long-term growth potential. The fact that these resistance levels tend to last for a while also made short-term price movements more predictable, offering a rare opportunity to do some short-term trading at slightly less risk than normal.
Secondly, and potentially more lucratively, this prolonged flat market impacted stock volatility. While the Dow Jones has stayed flat, volatility measures have collapsed. The VIX, which isn’t directly connected to the Dow Jones but is closely related, has plummeted to its lowest point in history.
This in turn has a ripple effect that is small but rarely predictable, again providing a short-term profiting opportunity.
Low volatility makes option premiums smaller, in turn making it cheaper to make high risk bets on short-term movements. It also lowers the risk of covered calls being assigned, in turn making it less risky to sell shorter-term calls and thus collect a higher income on sold calls without taking on significantly greater risks.
These are small, marginal means to profit but for a large fund they can quickly add up, especially if employed concisely and aggressively in a short time horizon.
But now that Dow is past 20k, the flat market opportunities are over and it’s time to think about what’s next. When stock indices break resistance levels at round numbers, they tend to swiftly go up or down depending on market sentiment. That means a spike in volatility, especially relative to recent low levels. That would indicate doing the exact opposite of the short-term volatility plays that have recently become available. But that opposite can be many things, so investors now need to choose whether to have a bullish or bearish bias. And that, sadly, is much harder to do than ride the short-term wave of betting on resistance.