Searching for a Silver Lining? Look to the Charts for Clues
So far, 2023 has been a difficult year for investors.
For this, we can thank intraday price volatility created by hedge funds’ short-term option strategies, as well as the Federal Reserve’s interest rate increases.
Still, you can always find a silver lining in the market’s clouds.
To do that, you can use several key indicators I’ll describe below. These indicators can help you make better trading decisions based on price chart analysis.
In this article, I’ll apply these indicators to the price charts of two recently volatile stocks: video game maker Activision Blizzard (NSDQ: ATVI) and IT monolith Microsoft (NSDQ: MSFT).
I bet we’ll find some clues about which of these stocks could have brightened a trader’s day.
It’s All About Volatility and Uncertainty
Options traders and short sellers love uncertainty because it increases volatility.
These traders focus specifically on Implied Volatility (IV), a major influencer of option prices.
The higher the IV, the higher the option’s price, if the expiration date is less than 30-45 days.
The closer you get to the expiration date, the faster the decline of the option’s time value.
For example, an out-of-the-money option’s price will decay faster within 10 days than within 50 days due to the pace of its time-value decline.
Short sellers often load up on put options — bets that the price of the underlying stock will fall.
If they’re wrong, they must reverse their bearish bets. This strategy reversal usually leads to a rise in the price of the stock about which they were incorrect.
Now, two phenomena tend to raise IV levels and influence bearish bets:
- Earnings reports
- Merger expectations
In fact, you can use these events to predict with a high degree of accuracy what may happen to the related stocks.
Support and Resistance
Before we get into the details, let’s review two important concepts in technical analysis.
Support is the price level at which stock prices stop falling and eventually reverse course. This is the price level at which the buyers come back.
Resistance is the price level where stocks stop rising as the sellers start taking over. Short sellers often use resistance levels as entry points for their negative bets.
When stocks fall below their key support levels, it’s a sign of increasing weakness. And when they rally from support levels or rise above their resistance levels, it’s a sign that buyers are overwhelming the sellers.
Short sellers often “cover” their positions at these levels by buying back the shares they borrowed to open their short trades.
At the same time, they abandon their option positions.
These option-strategy reversals often trigger rallies in stocks that short sellers had been targeting.
Two Key Indicators
Two technical indicators are useful in determining the amount of interest from either short sellers or “regular” traders involved with any stock.
The Accumulation Distribution Indicator (ADI) is a great way to measure short selling. Without getting into the weeds here, it’s sufficient to say that when a stock’s ADI line is falling, it’s a reliable sign that short sellers are betting that shares are going to fall.
For its part, On Balance Volume (OBV) is a reliable way to measure actual buyer/seller interest in any stock. When OBV is rising, it means that investors are buying the stock. When OBV is falling, it’s a sign that the buyers have turned into sellers.
The worst-case scenario for any stock is when ADI and OBV are falling simultaneously. The best-case scenario is when both indicators are rising.
Now that we’re all clear on the metrics, let’s take a look at MSFT and ATVI.
Microsoft’s Third Quarter
Microsoft shares soared more than 9% in one day after the company released its third-quarter (Q3) 2023 earnings report on April 25, 2023.
And since then, the shares have added more gains, trading above $310 on May 17.
But take a look at Microsoft’s price chart:
Before the earnings report, the stock lost 15 points over six sessions and broke below key support levels at $295 and $280.
At the same time, the stock finally found support above its 50-day moving average — a more reliable support/resistance indicator than the other price points below which the stock fell.
Much of the decline came in response to bad news from the U.K. about Microsoft’s plan to buy game maker Activision Blizzard.
We’ll talk about that in a second.
But first, note the similarities between Activision’s price chart and the Microsoft chart above:
The Mark of the Short Seller
Let’s focus on the Accumulation/Distribution Indicator (ADI) on both charts.
Specifically, let’s look at the ADI before April 24, when news broke that U.K. regulators had blocked Microsoft’s acquisition of Activision Blizzard.
First, let’s look at Activision’s ADI.
Note that, starting in early April, the ADI line began to slope down. This is a sign that short sellers were building positions, perhaps with the expectation that there would be bad news about the merger.
In this case, they were correct.
After the event — and the crash in ATVI — note that the ADI bottomed out as short sellers covered their positions.
By contrast, note that the On Balance Volume (OBV) indicator for ATVI moved lower for several days before finally ticking up. This means that the stock had few buyers.
This combination of indicators shows that buyers were betting on the sale, while short sellers were betting against the deal.
When the bad news hit, the short sellers made out like bandits as the shares melted down. But the buyers threw up their hands and fled.
Once the short sellers closed their positions with huge profits, the ADI started moving sideways.
Since then, European Union regulators approved the acquisition. The ADI has started to climb once again, while the OBV has bottomed out.
This tells us that short sellers are still covering their positions and that perhaps some buyers are making their way back into the shares.
Hope springs eternal. I wouldn’t go near ATVI for some time.
Use These Indicators As Clues
Making trading decisions based on the news cycle is a loser’s game.
That’s because by the time the news is out, the “smart money” has already taken its position.
On the other hand, the “smart money” often leaves clues as to whether an investment is worth the risk.
The relationship between Microsoft’s and Activision Blizzard’s shares is complex — especially because news related to the acquisition came shortly after Microsoft’s earnings report.
If you were a Microsoft shareholder, you might have panicked when shares sold off on the bad news about the Activision deal.
But a close review of MSFT’s price chart might have kept you in the stock because:
- MSFT shares never broke below their 50-day moving average on the ATVI news; and
- Microsoft’s ADI and OBV fell much less than the same indicators for ATVI. This was a sign that the major selling was in ATVI, not in MSFT.
In other words, panic selling hit ATVI, while cool-headed MSFT investors were rewarded when the tech juggernaut beat its earnings expectations.
The Bottom Line
The news cycle can distort any stock’s price trend temporarily. But there is no substitute for being aware of whether money is coming into or leaving a company’s shares.
Moreover, it pays to know what the short sellers are doing.
The combination of the Accumulation Distribution Indicator and On Balance Volume — along with classic technical analysis metrics such as support and resistance levels — can often make the difference between buying, selling, or holding onto a stock that is responding to a news event.
At the end of the day, it pays to follow these price chart clues.
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