The Path Of Least Resistance Is Down – Sell OTM Call Spreads

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

This has been an interesting week for the market. Monday, the market easily ran up to a major resistance level at SPY 144. That is a five-year up trend line that was broken in January, the 200-day moving average and a horizontal resistance level that dates back over a year. By late afternoon, sellers took profits and Monday's breakout attempt failed. That reversal paved the way for weakness the rest of the week. Tuesday morning, the PPI came in hotter than expected and the market quickly pulled back from the resistance level. Wednesday, dismal retail results and higher oil prices put early pressure on the market. In the afternoon, the FOMC minutes were released and that's when the wheels fell off. The Fed lowered GDP estimates for the year, they increased their inflation expectations, they raised their unemployment forecast and they made it clear that the rate cuts have ended. By late afternoon, the market was in a full-blown decline. Yesterday, the market held on to modest gains as oil pulled back. Unfortunately, oil is trading higher today and the market is down. The path of least resistance is lower and light trading could exaggerate the move. As you can see in today's chart, firm resistance has been established. Big down days that occur near relative highs are a warning sign. The first shot was fired two weeks ago and I have referenced it frequently. If the SPY 138 level fails, the SPY 144 resistance level will hold throughout the summer. Given the Fed's revisions, I would expect weakness in next week's economic numbers. They include new home sales, durable goods, GDP, personal income and spending, the PCE deflator, Chicago PMI and consumer confidence. The earnings will be dominated by retail and Sears and Costco are to the big names that will post results. Two months ago we were worried about a full-blown financial collapse. Surprisingly, the market rallied to within 7% of last year's highs. Since October, food and energy prices have spiked. I just read a report that 55% of Americans discretionary spending is being allocated to essentials. Unemployment has climbed and corporate profits have slowed in the last 8 months as well. If I read the Fed's statements correctly, interest rates will start to climb this fall. In June and July we will have another huge round of mortgage resets and I believe the Fed will wait to see how that pans out. All of these factors will keep the SPY 144 level in tact this summer. On the flipside, if you strip out financial stocks, the earnings growth rate has been pretty decent. Companies with a global footprint are making money internationally. If we can get some relief from energy prices, the market will respond. In the chart you can see a horizontal support level that has been drawn at SPY 132. That was the low from last March and August. Once the market rallied from the double bottom in March, it found support at this level. There were two large up gaps with aggressive buying at this level and I believe the SPY 132 level will hold. My conclusion is that we will be range bound. As you know I have been selling call spreads on financials and retail/restaurant stocks. Those trades are working out well and as long as you stay short consumer related stocks that are reliant on US revenues, you will fare well. I am happy to see commodity stocks pull back. They are overbought and the speculative "fluff" needs to be chased out. When these stocks find a bottom, they will present an excellent buying opportunity. The fundamentals have not changed and demand continues to outpace supply. There will be excellent trading opportunities on both sides of the market, but don't expect fast profits the summer. We are going to fall into a trading range until we have clarity from the financials and economy stability. For today, I would continue to sell call spreads on financials, retail and restaurants. The market momentum favors the downside and we have broken below SPY 138. Trading will pick up toward the end of next week and the market will take its direction from the economic releases and oil prices. Have a great Memorial Day and please remember and to honor those who have made this country great. image

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