Question

I have read your 6/22/07 market forecast of a bullish 6 months ahead. I really enjoy your authenticity and candor on everything I have encountered on your site thus far. Humbly.. I am seeking your experience and wisdom on a “what if” position that is contrarian and extremely bearish especially for the fall 2007 through early 2008. I believe we are headed for a HARD fall (12-20%) sometime in Octctober 2007 I would like to invest concisely with this viewpoint. How would you construct option trades over the next few weeks/months if you were certain of a major downturn this October?

Answer

Thank you for the kind words regarding my analysis. Before I get started let me clarify a point. I am short-term bearish and long-term bullish. I believe the market will pullback to test the SPY 146 breakout and rally from there. If you are extremely bearish, here is some advice.

First of all, nothing is certain. Your confidence is extremely high and you need to temper it. I can tell you from personal experience that picking market tops is a losing proposition. I watched many “certain” traders pile into puts in the fall of 1999. They were ultimately right, but they lost everything because they were a few months early. If you were to start accumulating bearish out-of-the-money puts with 6-8 months of life, you would be properly positioned given your opinion, but you would stand to get wiped out if the market holds up. You used two words concise and humble in your question.

When you mention the word concise, know that it is nearly impossible to pinpoint market reversals. You are going against the trend and there will be many headfakes (like the one in February 2007) that make you think the market is heading lower. They are called “bear traps”. Don’t worry about the first 5% of the move, focus on what follows. In our current situation my market opinion will change if the SPY 146 breakout level is breached. At that point I too will be bearish. That support level is very significant and if the buyers can muster a “bid”, it means a top has formed. After a failed breakout, I can take short positions with confidence. If you read my series, Option Trading Strategy For “V” Bottoms you will be properly positioned. In the event that the decline is something more than a “V” bottom, I advise you to let the market tell you what to do. In Leg #3, we are trying to hold onto our short positions and we only want to bail on them if the market is finding support.

When you use the word humble in your question, don’t be humbled by my presence. I am simply a student of the market. Be humbled by the market – it is always right. Keep your game plan very flexible. It’s good to have confidence in your analysis, however, be prepared for the likelihood that you are wrong and know when to cut your losses.

I continually prepare for the unexpected. Everyday I search out my most bullish and bearish pick of the day. This keeps my perspective in check and I accumulate a watch list of stocks that have relative strength and relative weakness. That is my edge. If I believe the market is going to rally and I buy calls on extremely strong stocks, they will hold up relatively well if the market declines. This gives me the opportunity to exit the position and to contain my losses. Consequently, my market prediction could be wrong and in many cases I will still make money on the trade. I publish a research report called the Daily Report and at a moment’s notice, I have a ready made list of longs and shorts. I also have a dynamic table that monitors the bullish and bearish watch lists and I immediately know where to look when the market conditions are changing. When the market throws uncertainty at me, I am not scrambling for ideas. I know exactly what to do.

If you feel confident that your scenario will unfold, this is the time to do extensive research to identify weak stocks. Don’t place any trades until the market cracks and the stocks demonstrate that they will lead the move lower. Look for stocks that have already formed a top and have not been able to rally with the market when it recently made new all-time highs. If the stock has broken a support level recently, it might qualify as a good short.

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