Trade Small and Favor the Downside. Buy Puts if We Close Below SPY $140.

November 28, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

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Yesterday, the market declined late in the day. Last week’s holiday rally ran out of steam and comments from DC have lacked substance.

Traders will scrutinize every word out of Washington and the market will gyrate back and forth. In the early going, politicians will be given the benefit of the doubt. However, with each passing day, the selling pressure will build.

Politicians rarely do anything that involves pain. They will wait for the last-minute and eventually a market decline will force them to take action. The finger-pointing has already started.

Even if all of the tax hikes are implemented, the revenue gains will only finance our government for eight days. Think about this, it really puts the whole situation into perspective. The “rich will pay their fair share” and it only pays for eight days of government spending.

Republicans have stated that they will agree to tax hikes. However, Democrats have yet to counter with any spending cuts. Entitlement reform is not even a consideration and this is the 800-pound gorilla.

We will hit our debt ceiling in the next couple of months and Democrats want to roll that into any possible fiscal cliff agreement. They don’t want to go through this process again. This is the Republican bargaining chip. The Democrats have one too. If we go over the cliff, tax hikes take effect right away and they can postpone spending cuts.

There are factions in both parties that seem willing to let us go over the cliff.

Decades ago, politicians would kick the can down the road and it would roll downhill. Now they are kicking the can up a steep incline and it keeps rolling back. We will revisit this problem again and again. Look at Greece, they barely secured this bailout payment and they are already negotiating for the next one.

Small tax increases and minor spending cuts (best case scenario for the market) would still weigh on economic growth. GDP is growing at 1.3% (if you strip out year-end government spending). If Washington reaches a watered-down solution, we will still barely tread water. This would require politicians to miraculously work together. Unfortunately, our deficits will balloon and our credit rating will suffer if we go down this path.

Europe is officially in a recession, Japan has a fiscal cliff of its own and China’s stock market is making a new multi-year low. Our economic activity is hanging on by its fingernails. I don’t see a catalyst for growth.

Consumers are tapped out and the average baby boomer as less than $50,000 saved for retirement. Most are worried about their job security and they are saving.

The Fed has thrown the kitchen sink at the economy and is out of bullets. Quantitative easing has not stimulated economic activity and interest rates are at zero (US, Europe and Japan).

Corporations see the storm clouds and they are hoarding cash. They know that a double dip recession would impact credit and they want to stay liquid. Headcounts have been reduced and expenses have been slashed. New regulations, Obamacare and the fiscal cliff will keep them on the sidelines. Corporations will only invest if they see a sustained uptick in demand.

This is historically a very bullish time of year. When the market can’t rally into Christmas, it is a major warning sign.

I believe the market will drift lower and politicians won’t be able to reach an agreement. Rumors of a deal will spark short covering and it won’t be easy to stay short.

At the last minute, politicians should find a solution. The market will rally on the news and once that move runs its course, a long-term short will present itself.

Traders know that no matter how you slice it, trouble lies ahead. They simply don’t want to get caught in a short covering rally. They will sell into strength and they will be quick to take profits when the market declines.

That will be my strategy as well. The SPY has broken support at $140. The downside was tested early and we bounced. I am buying puts. I believe the 200-day moving average will be tested in the next week. If that level fails, we will see a strong wave of selling. That will force politicians to take action and I will be covering.

Major economic releases will hit next week. However, hurricane Sandy will be blamed and traders will give the numbers a free pass. I believe that even without Sandy, there is a strong undertow.

Buy puts and use a close above SPY as a stop. If we break below the 200-day moving average, buy more puts. I don’t believe politicians will forge a deal this early and I am comfortable being short. Be prepared to take some heat. There will be rumors of a deal and you have to weather those rallies.

Keep your size small. I hate taking large positions when all we are really trading is news out of DC. The tone can change quickly.
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