Back in the saddle

Happy New Year! Recently I have been thinking about some life changes that I would like to make in the new year - and resurrecting this blog is one of them. While I have been quietly trading for the past couple of years I have been remiss in documenting my predictions and results. So here's to turning over a new leaf...

Recently I heard a market analyst state that you could tell what the market will do over the course of the year by looking at the first 5 trading days. An examination of the first 5 days of trading in 2011 of the SPY shows:


SPY opened on Monday 1/3/2011 at 124.11 and closed Friday at 124.53. A change of .3% (point three). The SPY closed on 12/30/2011 at 125.50 - about a 1% move. So, the first 5 days seemed to forecast a flat market - and it turns out that even with all the market gyrations and machinations the market finished the year.....flat.

On to 2012....

At this point we have only logged 4 days of trade, so we will see what Monday brings. For now we have the SPY opening on Tuesday 1/3/2012 at 127.76 (more than a $2 gap up from the year's close). Friday's close was 127.71 - looking pretty flat so far. Stay tuned for a Monday update.

Finally - a predictable and rational market

There - I've said the "P" word - I've made the proclamation that the market is acting PREDICTABLY. Now I have to put a stake in the ground and make a prediction - and confidently back it up with a position. So here goes...consider this daily of the SPY:



Take a look at today's volume and the previous two volume spikes...all significant down days. The volume trend has been steadily declining since the spring while price action has been trending up. What does this mean? It means that the big, institutional money (mutual funds, pension funds, hedge funds, etc.) are sitting on the sidelines, unconvinced of the economic recovery. Biding their time with each passing week waiting to see some market fundamentals that would validate the "V" shaped recovery. But nada, zip, squat. No validation - just unbounded exuberance exhibited by the "small" money a.k.a. the retail investor.

Back in mid-July the market cracked the 50 day Moving Average but ultimately found support just below on the still down trending 200 day Moving Average. This event occurred not long after the 50MA crossed above the 200MA, which is often a time when the institutional investors start thinking "long". (BTW - the 50MA and 200MA are fundamental technical indicators that all the institutions use.) Not this time - again the big money stays on the sidelines. Volume continues to taper off until September 1 (the beginning of the traditional "correction month"). Bam! Big money steps in and drives the market back down below 100. We get support at around 99. The last time we had support at this level was mid-2004 where we tripled bottomed on a basing pattern. We got the anticipated bounce on virtually no volume and then saw 3 days of decent volume spikes (actually still below average for the SPY) on up moves. Followed by 3 flat days and then 3 down days - a wash. The next big volume spike comes on a big move down and is spread out over 2 days (9/30 and 10/1). Now the down trend in volume is broken and a prudent trader starts looking for an entry point - the big money is back in the game and they are going to move the market. Which way? Down!

Today's price action confirms (at least for me) that the institutional investors (who are the real market movers) are in and they are eating the lunch of the over exuberant retail investor. The SPY cracked its support at 103.85 and closed pretty much on its low. I believe we are seeing the formation of a Head and Shoulders pattern - the left shoulder and head are pretty obvious on this chart. My prediction? Next week the selling resumes and we move down to the 102 level. A bounce on low volume will take us back up to about 107...and then the bottom falls out and we head down to the 200 day Moving Average and the mid to low 90s.

I will go long as we are bouncing off of 102 (by selling SPY puts - probably the Dec09 100. The rise in price will cause these to bleed volatility and I'm happy to collect that - I'll buy them back when we get up to the 107 area. At that time I go short by purchasing deep in the money SPY puts that are a few months out - probably the Jan10 113. These babies are far enough in the future that they won't get hurt as much by the rising volatility created by the free falling market.

There - I've done it - a trifecta of "P" words - Proclamation, Prediction, Position. Now we wait and see.

Change is afoot

I have been sitting on the sidelines for quite sometime - mainly because the market's volatility indicators, in my opinion, cannot be trusted. With that as my prevailing attitude, I have not been able to bring myself to resume trading after the whupping I took last year. Today I see change afoot - let me explain starting with a picture:



Today's big body white candle represents a pretty significant upward move after a couple of down days. On the surface it looks like the continuation of the bull rally after after a couple of days of consolidation. The volume, however, tells a different story. Today's volume of just under 118M shares traded tells the real underlying story. The last time volume was at this level were on the days surrounding the last Christmas holiday. Prior to that it was Thanksgiving. Prior to that was May 30, 2008 - arguably the first summer weekend of the 2008. These lackluster levels demonstrate complete lack of interest by institutions and large scale traders. Let's wait and see what Tuesday brings...

An awful month

Fort the most part this past month has been awful for traders. The market lacks clear direction and the volatility creates an environment where Technical Analysis is almost useless. There - I said it - Technical Analysis is almost useless. Over the past month I have had some terrific gains but have had even more "terrific" losses. Currently I am on the sidelines in observation mode, although I do have a small delta positive investment position. I believe there is some upward movement in our distant future so my bullish position is made up of stalwarts such as AA, CAT, DIA, GE, and XLF. My strategy is to collect their dividends and sell Covered Calls at the height of the bounces. If they get called away, then that will be evidence that the bull is back and I can start counting on some upward direction.

This is a good time to exercise patience and invest in education.

The passing of the Bailout Bill

This has been an unprecedented week in the financial markets. First the House does the right thing by asserting the will of the people and rejecting the Financial Market Bailout Bill. The Dow Jones Industrial Average falls 777 points - the biggest one day point move in history. The House goes on recess. Next the Senate gets a hold of the Bill and adds a ton of "pork" to it in order to purchase "aye" votes for passage. After passing on Wednesday evening in the Senate the index futures sell off and set the market up for another 340 point drop the next day. Back to the House...the "pork" works its magic and the required number of "aye" votes are garnered. The Dow was up 250 points prior to the vote and sold off 400 points closing down 157 on Friday. Glad that's all behind us now.

Now what? Let's step back and look at the big picture ($DJI 10 year monthly):


You can plainly see that just 3 days into the month of October the Dow has penetrated a key (50%) fibo level as well as an uptrending linear regression line. These broken support levels foreshadow a continued bear market that will take the Dow down to the 9900 level in the near term. If that level doesn't hold then we will probably see 9000 and may be looking at a complete retracement of the 2003 - 2008 bull market which would take us to 7250.

How about the S&P 500 ($SPX 10 year monthy)? Take a look:


We blew through the 50% fibo last month and have not looked back in October. The next key level of support is 1075 where the 61.8% fibo and an uptrending linear regression line converge. If that support level fails we could free fall to 925.

Bottom line for me....this is bear market and I will continue to trade it like one. Although the VIX is quite high at 45+, I am not convinced that we have reached capitulation. The ban on short selling will expire next Thursday night and that should bring some sanity back to the market. Ironically, it may be that singleton event that turns this market around. We shall certainly see...

Huh?

This past month has been full of craziness - so much so that I have had nothing constructive to say in my blog. That doesn't mean I haven't been profitable, in fact the past month has been the most consistently profitable trading my account has seen in quite sometime. Many friends have recently asked (somewhat fiendishly) how I'm doing in the market - they are obviously looking (dare I say hoping) for me to say that my ROI has been at least as poor as theirs. When I respond that I have done quite well by taking advantage of the downward move in the overall market I am often met with silence, or a stare that says "Oh, you must be one of those anti-American short sellers that I hear about on CNN." Nothing could be further from the truth and I would like to devote this blog entry to the explanation of how to capitalize on a down trending market.

But first things first...I don't short sell equities. Period. I believe an outright short sale of a company's stock is a bet against the company and the hardworking people that are employed there. It's a personal thing for me - I don't necessarily think short selling is bad, I just don't do it. Short selling plays a vital role in free and open markets by embedding stock buyers at various price levels. If someone borrows a stock from their broker and "shorts" it they have to "cover" at some point by buying the stock back and returning it to the rightful owner. If they buy it back for less than they sold it for they make a profit and if they buy it for more than they sell it for they take a loss. It is this required buying that puts the brakes on a downtrending stock. When you look at an overall downtrending chart and see upward spikes in the price action that last for a couple of days before resuming the downward trend you are witnessing what is known as a "short squeeze". The short positions are buying to cover and driving the stock price up. Not until all (or most) of the shorts have been forced to cover will the price back off and continue downward. If that forced buying wasn't embedded in the markets you would see out of favor stocks (poor earnings, missed FDA approval, false rumors, true rumors, etc.) plummet without pause because there would be no buyers - and that is bad for the company's stock holders, employees, and the market in general.

So....how do I capitalize on a down trending market? I use Options and ETFs (Exchanged Traded Funds) to assert my bias against other market speculators.

If I think the S&P 500 (for example only) is going to tank I step back and watch it...and look for a high probability trading opportunity using equity options to define my projection. When I buy a put (or sell a call) I am taking a bearish position against the speculators that are thinking otherwise. That's what options provide - an alternate market that allows speculators to trade against each other. When I take a bearish option position, I'm taking the other side of another speculator's bullish position - they are typically buying a call (or selling a put). In the end, only one of us is correct and gets paid - the other has to pay up. In this type of market, the speculators are asserting their views against one another and are not directly influencing the price action of the underlying stock. The price of the options are determined by various things - the price of the underlying stock, option supply and demand, time remaining until option expiration, and volatility.

It bears mention at this point that I very rarely trade an individual company equity. Almost all of my trading is done on index and sector ETFs. This limits my risk by reducing my exposure to the unexpected swings of a specific stock in the event of unexpected news or reports. ETFs are often called a "basket" of stocks. One of my favorite trading intruments is the DIA (called the "diamonds"). It is an ETF that tracks (pretty closely) the Dow Jones Industrial Average. When the DOW moves up 100 points, the DIA moves up 1 point (dollar). I typically trade the DIA using complex option strategies that allow me to have defined risk but limited ROI - a trade-off that I am more than happy to make. For example, if I forecast that the DIA (and by extension the DOW) will not fall below $110 in the next 30 days I would sell a DIA OCT08 110 PUT and purchase a DIA OCT08 108 PUT to hedge the position. This is called a credit spread and basically allows me to keep the difference in the 2 prices if I am correct in my forecast. I will dive deeper into credit spreads in my next post...

No time like the present

I have been patiently waiting for the DIA bounce to de-materialize and I think we finally have a break of the flag pattern's lower trend line. Check it out...

I am quite excited about this week and the near term future as the DOW (and subsequently the DIAmonds) sets up for a significant plunge. As of this writing the E-mini DOW futures are showing a morning opening below the trend line. I expect that buyers will step in and force a test of the ascending trend line - if that test fails to break through then the bears will be out in force with a DOW target of 10200 (102 on the DIA).

The SPY has the same basic pattern as the DIA, but has not put in a close below the ascending trend line:


That said, it pierced the 38.2 % fibo with conviction - but the trend line held and the lower tail kissed the 20MA so there is a touch more support to crack. Some bad economic news in the morning should soften these support levels up nicely and bring the bears out looking for 113 on the SPYders.