- Created on Friday, 05 August 2011 16:07
- Written by Jared Levy, Editor, Option Strategies Weekly
- Hits: 3026
I often say the stock market is always looking three to six months ahead with tunnel vision.
But from time to time, the market stops to take a look around. When the blinders were removed last week, the market realized it was no longer in Kansas. A swirling tornado of debt, economic and consumer weakness, and near frozen credit conditions across Europe brought a rude awakening to what has been a careless stroll for equities.
Some traders are calling for the markets to retest their 2009 lows. I have my own theories on that, which I will share with you shortly.
The next question is, will the tornado unwind, or will this swirling mess spin faster? You would be surprised at what some of my friends on Wall Street are doing.
When Margin Calls...
In just two weeks' time, the Dow Jones has lost over 1,200 points. More importantly all three major indexes not only have gone negative on the year, but have all broken below their 200-day moving averages. This is an extremely bearish sign and usually means a bull market is coming to end.
In seven of the past nine days, selling seemed to pick up just before the markets closed. At the same time, volume increased. In my experience in the pit, when investors are selling into the close on a down day, we are entering a bearish market.
This selling snowballs when traders who bought on margin have to sell their shares to cover margin costs. Typically a trader will wait until the very last minute to execute this trade: The calls come at 3:30 p.m. ET.
Look at the 15-minute chart below. I placed the volume over the price chart to illustrate the dramatic spikes at the end of the day. (Each gray vertical line represents one day.)
This shows a fearful investor scrambling to cover his long positions over the past week.
I want to point out several chart patterns that led to yesterday's huge sell-off. I'll also show you the areas where we are going to have trouble climbing higher.
In the S&P 500 daily chart below, you can see a big ole head-and-shoulders formation. That triggered June's sell-off.
We then bounced right back to the level of the second shoulder, where the S&P immediately failed (on July 7). Over the next week, the S&P made another run for the money, only to be stopped again at 1,345 on July 22. This formed the bearish double-top pattern that began the nine-day slide.
At that point we were still above the 20-, 50- and 200-day moving averages... what a difference nine days makes.
The market now finds itself way behind the eight ball. It has blown through five major support levels, and if we don't immediately recover above the 200-day moving average (in red), expect a bear market for the next couple months or more.
In a bear market, the rules change right along with the sentiment: Traders sell the rallies instead of buying them. When the market drops, traders might only cover part of their short positions because they are expecting more selling.
Because of this and other factors, the bear market becomes a self-fulfilling prophecy.
A bear market also takes away from consumer confidence and spending, further hindering economic growth. The market has a large amount to digest here and it hasn't been a good meal.
The worst part is that investors can't stomach much more of this bad data. If there is to be support in the markets, stability here and abroad must be apparent.
You Versus Them
The smart money started selling weeks ago. I saw it in the option markets and I heard it in the pits when I listened to the S&P futures trade. But now some of them have slowly started to nibble on long trades even with all the apparent doom and gloom.
Professional traders will always take advantage of panic. While the payoff may take some time, history shows us that if we buy the severe dips, we get better profits over time.
If you are going to be invested for three years or more, a simple strategy can reduce your risk. I'm talking about selling out-of-the-money puts on quality companies like Apple (AAPL:NASDAQ), Google (GOOG:NASDAQ), IBM (IBM:NYSE) and other quality companies that have shown resilience in this mess.
Some of the most powerful funds out there are using this same strategy.
Panic and fear cause options prices to rise. The Volatility Index at 32% tells me that options cost double what they did just a couple weeks ago. This means that now is the time to be selling options, not buying them.
If you want to buy stock, selling a put is a great way to do it at a discount. Selling one put option obligates you to buy 100 shares of the stock. You get a cash credit in your account when you sell a put, and that can help lower the cost of buying those shares.
Out-of-the-money puts mean the strike price of the put option is lower than the price of the stock. Let me show you what that looks like with an example.
Right now IBM is trading for $172 a share. What if I told you that you could buy IBM for $165 and get $2.40 per share to do it? This is what would happen if you sold the August 165 put. This is a solid strategy for longer-term investors. Now may be the time to start selling out-of-the-money puts on companies that you want to own.
If you don't understand the strategy, I recently discussed it in detail in our new podcast series with my colleague Joseph McBrennan. It's part of a series of commentary and strategy sessions. You can check them all out all our free podcasts.
Publisher's Note: When it comes to option-trading strategies, Jared is one of the best on Wall Street. But what most people don't know is he is a different kind of trader. He doesn't swing for the fences -- a strategy that leads to far too many strikeouts.
Instead, he aims for consistent singles and doubles. Each of his weekly trades can boost your portfolio by 20%, 30% even 40%... and they'll do it with a success rate of over 80%. Jared boasts a track record that is the best in the business. To see his strategy revealed, follow the link.
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