Bounce Or Breakdown – We’ll Know Soon – The Option Trading Approach!

October 23, 2008
Author: Peter Stolcers, Founder of OneOption

It has been a tough week for the market. After another failed rally, the SPY was turned back from the $98 level. Now, it stands at the lows from last week and the $88 level needs to hold to preserve any hopes of a market bounce. Fortunately, the credit markets have stabilized and they are showing some signs of improvement. The LIBOR rates continue to drift lower and banks are conducting business with each other. This was a major hurdle for central banks. We were on the verge of a financial collapse and for the time being, that bullet has been dodged. It's tough to stomach the selling pressure that accompanies every rally, but the price action this week does not scare me nearly as much as the panic we saw a few weeks ago. Traders can deal with a recession related market decline because they are familiar with the event. On the other hand, none of us have experienced a financial collapse and the thought sends shivers down everyone's spine. The market has slightly factored in a doomsday scenario and that means it has more than compensated for weak earnings news and deteriorating economic conditions. Consequently, a rally could materialize as earnings are released. We are currently entering the two most bullish weeks of the year and the rallies have been of a much greater magnitude when they follow big declines. Sentiment indicators are at extreme levels and from a contrarian standpoint, we are due for a rally. For instance, the VIX is at a historical high. It has tested this level three times and it is poised to roll over. Hedge fund liquidation has pushed many great stocks down to bargain prices. Brokerage firms doubled (and in some cases tripled) margin requirements and the selling was forced. Investors are also heading for the exits and mutual fund outflow has been unbelievable. From its all-time high one year ago, the SPY has lost almost 50% of its value. From a technical perspective, that is significant. The de-leveraging process is well underway and there is cash on the sidelines. I believe the long-term outlook is dismal. However, the Fed's action has prevented a meltdown and we now have a chance for an orderly decline. It will take us five or more years to work our way out of this mess. Homeowners are watching real estate prices fall and 1/6 of all US mortgages have negative equity. That number has doubled in the last year. Those who have stock market investments have seen their portfolios get cut in half. Unemployment is on the rise and people are wondering if their job is secure. The key to trading this market will come in the next two days. If the market easily tests SPY 85 (or worse - it breaks down), we are likely to make new lows. In that case, keep your powder dry. The option premiums are too rich and put buying will not yield big profits. If you are a day trader, short stocks. Make sure to cover by the end of the day to avoid overnight risk. If the market finds support above SPY 85 and it can stage back to back rallies, we are likely to see a bounce. In that event, sell OTM puts on stocks that have a defined support level. Option premiums are at extreme levels and you will be well rewarded for taking that risk. Distance yourself from the action and make sure that there is a support level above the strike price. image

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