Trade the Rally. Keep Tight Stops and Limit Overnight Exposure. Horizontal Breakouts Are the Best Be

August 15, 2012

Yesterday, the S&P 500 closed $.70 lower for the day. The market is flat this morning and it hasn’t moved in over a week. We can expect very quiet action as politicians and traders take time off.

The economic releases are minor. Empire Manufacturing came in below expectations this morning and industrial production was a little better than forecasted. CPI was benign and the market did not budge after the news. Initial claims are filled with seasonal adjustments and the release will not have much of an impact. The next major economic release will hit a week from tomorrow (flash PMI’s).

Earnings season is winding down and this week we will hear from retailers. The results will be mixed and discounters should fare well.

For the time being, statements from the ECB have pacified European credit concerns. Eurocrats are vacationing and that gives the false impression that EU members are all in agreement. In a few weeks they will return to office and the rhetoric will fire up.

The ECB’s plan will support short-term bond auctions. However, sovereigns will have to apply for bailouts with the EFSF and they’ll have to prove themselves worthy. Member nations (strong and weak) will have to contribute to the EFSF and that is where the “rubber meets the road”.

Italy and Spain account for 20% of the EU’s GDP. The bailouts will be massive and structural deficits will pull them further and further into debt. Without entitlement reform, they will keep coming back to the trough.

As long as the market believes that the EU will stay ahead of the curve, the market will grind higher. The instant that changes, the rug will get pulled out.

This is a very dangerous market. Option implied volatilities are near historic lows and no one is looking for a major decline. Central banks are backstopping the market and if conditions deteriorate, traders feel they will jump into action. Unfortunately, their actions will have a minimal impact and the market will continually demand another “fix”.

Be very, very careful when selling premium. The market probably won’t make any big moves, but most of the “juice” has already been sucked out of the options. You are not being properly rewarded and stock selection is critical for this strategy to work. This is an option buyer’s market.

When stocks grind higher day after day it’s easy to get lulled into the rally. Volumes are extremely low and that means conditions can change rapidly.

Trade the upside and maintain tight stops. The SPY will hit resistance at $142 and it probably will not get through on the first attempt. If we get a dose of good news, we will poke through.

A breakout next week would trigger stops and shorts would be forced to cover (bearish sentiment is low and the squeeze will be minor). Speculators will buy the breakout. Once that momentum stalls, we could be set up for a quick decline.

Trading this market is like walking on thin ice. I will wait for colder temperatures so that I can walk across safely or I will wait for a thaw so that I can use a boat. It does not make sense to take large positions in this environment.

As I mentioned yesterday, I am day trading stocks like HD from the long side.

Keep your positions small and limit your overnight exposure. The market should be able to move higher this week.
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