Watch For Capitulation – The Next Big Move Is Up. Sell Out of the Money Put Spreads

February 4, 2014
Author: Peter Stolcers, Founder of OneOption

Yesterday, the market started off on a weak note and ISM manufacturing added fuel to the fire. The SPY easily blew through the 100-day moving average. Asset Managers are not engaged and they will wait for bona fide signs of support. The market drifted lower throughout the day and there were not any bounces to flush bears out of their positions. Capitulation lows are typically not resolved overnight. Stocks are bouncing this morning, but the move needs to gain traction immediately. Once this rally stalls, traders will probe for support. If the selling starts early in the day, we might see a dip, a sharp reversal and a grind higher. That would be bullish. If the market rallies and stalls mid-day, we are likely to see late day selling. This would be bearish. From a technical standpoint, we are on a major support level (SPY $173.60). That was the breakout in October and it represents horizontal support. This is also the long-term trend line that dates back to June. ISM manufacturing was weak, however much of the decline can be attributed to bad weather. (construction was down dramatically). The jobs reports this week will be critical. Tomorrow, ADP will be released. Analysts are looking for 175,000 new jobs in January when the Unemployment Report is released Friday. They are also expecting an upward revision to December’s number. Initial jobless claims have been decent and I believe the employment data will restore confidence (even is the number is a bit light). China's activity is slowing, but a 7.7% GDP growth rate is nothing to scoff at. Europe is finally showing signs of improvement and for the time being it will not weigh the market down. Earnings have generally been good and profits are up more than 7% year-over-year. Bad weather is impacting certain groups, but the overall tone has been positive. The sell-off we've seen in the last week has a liquidation feel to it. Hedge funds are exposed to the carry trade and margin calls are forcing them to cover positions. I don't believe the decline is credit related. That might be playing a small role, but PIIGS yields are stable and fear is not spreading. China will bail out its failing investment trust and that is not a major concern (until others surface). Global markets are adjusting to tighter credit conditions. The Fed did not flinch when Turkey and Argentina (and other emerging markets) were experiencing currency issues. This caught some funds off guard and they are scrambling to adjust. I mentioned yesterday that I was not going to short this market. The macro backdrop is still intact. We had a similar 100-point drop last June and it ran its course in a little more than a week. Rumor has it that Republicans will extend the debt ceiling if the Keystone Pipeline is approved or if the risk corridor (HMOs get government protection from insurance losses) is removed. These demands are very minor. President Obama has come under fire from both parties to approve the pipeline. This seems like a slam dunk and a debt ceiling extension would be very bullish. In each of the last market declines, the 100-day moving average has been breached. This serves two purposes. First of all, it flushes out bullish speculators. Secondly, it attracts shorts. Once that capitulation low is established, Asset Managers buy with vigor. Shorts scramble to cover and bullish speculators jump back in. This results in a snapback rally. We are close to a bottom. Don't waste your time with shorts. Focus on the bounce. That will be a much better trade and you'll miss it if you are scrambling to cover your short positions. Don't be too eager to buy the early bounce today. Let the dust settle and see if the momentum can be sustained later in the morning. Even if you miss the first 20 points of this bounce, when you do get in, you can do so with confidence. The selling yesterday was nasty and I expect to see some volatility. If you are compelled to get long at this level, sell out of the money put credit spreads on strong stocks. This strategy will allow you to distance yourself from the action and you can take advantage of time decay and inflated implied volatilities. The next big move will come on the upside. If you are short, I encourage you to take profits on some of your positions. . image

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