How to Play the Downside in High Volatility Situations

Alarming factors have resurfaced in the market recently. Some are fundamental, some technical, but all are negative!  

On the fundamental side, several problems thought to be under control and improving turned out not to be. The housing market is beginning to show signs of the reality of the housing situation and not the fantasyland government skewed perception of what they want you to believe it is. Unemployment which was supposed to be getting better surprisingly dipped again.

Further, there are reports (and in my mind definite evidence) that the banks are not out of the woods and really never were according to world banking analyst Meredith Whitney who is more bearish now than ever.  And let’s not forget the problems in Europe with sovereign debt and now news that the European Banks balance sheets and debts are being called into question.

On the technical side, the DOW, after making a lower low, has just put in a lower high due in part to a failure to break above the 50 day simple moving average.  These factors point to the beginning of a new downtrend on the horizon. If we believe that the stated factors indicate a downside movement, our next move seems easy…..just buy some puts, right?

Well, maybe that is the right thing to do but there is a consideration. That consideration is volatility level. If we take a quick look at the VIX, we see it at 27 or so. While that is not a screamingly high volatility, it is also not low and it can create a worrisome amount of extrinsic value (value that can decay) in those puts you want to buy. In times like this where higher levels of volatility make option prices expensive, the purchase of speculative puts can become dangerously prohibitive.

In this scenario, the use of a well constructed put spread in the SPYDERS or the DIAMONDS can be a portfolio saver. Debit puts are constructed as premium collectors (i.e. selling the at-the-money put and buying the in-the-money put). If you are correct and the market gets hit, your put spread will be profitable. If the selling gets aggressive, you can always morph the spread to a straight short stock replacement put by buying back the short put. If the market stays here or drifts down a little, you have the premium collection working for you.

You have some room if the market goes up against you but ultimately have a limited loss scenario in this put spread as you can only lose what you spent purchasing it. These spreads are normally inexpensive but do provide good percentage returns in a short amount of time. So, if you are expecting downside but are worried about the cost of puts due to high volatility, look into the premium collection put spread.

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The Ultimate Contra Indicator?

Finding a bottom in the market or an individual stock, especially one that is in major distress and under the pressure of panic selling, is a very difficult thing. The lure of buying when everyone is selling is that the rebound is normally strong and quick and extremely profitable for those willing to buy when everyone else wants to sell and vice-versa.

Many professional traders will tell you that they love doing the opposite of what everyone else is doing. To be honest, for those that have no fear and can stand a little short term pain, the contrarian trading style usually works well.

So, other than doing the opposite of what it seems everyone else is doing, are there any good legitimate contra indicators out there? Sure there are and we all know a few. Some people like to use the put/call ratio. They say that when more people are buying puts, it is time to get long and when more people are buying calls, it is time to get short. There are questions as to whether this works or not but regardless of that….even if it does work, it does not indicate timing. As you know, too early jumping in and much pain can follow before payday comes. Too late and you could be chasing payday instead of capturing it.

Now, I don’t want to make any accusations. I have no proof of anything but, when it comes to timing, a downgrade by Goldman after a stock has already traded down 45% or so, raises my eyebrow! I have heard that studies show that individual investors are normally heavily invested in the market during market highs and they seem to be only lightly invested at market lows. There is much speculation as to why this happens. Maybe it is because Wall Street creates this situation. It is no secret that Wall Street has been accused of representing itself instead of representing their customers. Maybe, Wall Street puts out upgrades at market highs to lure in buyers so Wall Street has demand to sell to so they can sell the top to their customers? On the other side, as in this example, maybe Wall Street likes to put out downgrades and sell recommendations at lows in order to get investors to sell at bottoms so that Wall Street can have supply to buy at bottoms.

If that is true, then a downgrade down at this level as Transocean (RIG) and other oil related companies might signal a bottom. It makes you wonder how a company like Goldman who we all know is more politically connected than any company out there, a company who has stated that they made money trading every day except 17 over the course of the last year, can miss downgrading a stock involved in a major oil spill until the 50^th day of the spill and at a price that is down almost 45% from where it was when the spill occurred? They did not downgrade at $90, or $80, or $70, or $60 but they wait until under $50. Something is not making sense here. The great, mighty and all knowing Goldman did not see this as a sale until now? I think something smells very, very fishy!

I am not sure if I am right but I have experienced this on more than one occasion and let’s just say that the likely suspect is involved yet again!  I would start watching this area from an educational standpoint to see if a bottom forms right around here. If it does, observe a few more examples and you may just find the ultimate contra indicator!

There’s the PPT !!!

Back on Memorial Day Friday, May 28^th, I questioned the fact that the PPT was noticeably and surprisingly absent at a time when the market was about to break the DOW 10,200 support and close below that, which would be a very negative, bearish close. The timing was also excellent for an intervention because of how illiquid the Friday before a long holiday weekend is; the first weekend of the summer with good weather expected………especially after 3:30pm.

I stated in previous posts here in the blog that the fact that they did not show up was noteworthy. It was almost as if the PPT had decided not to defend the DOW 10,200 support level and fall back to support the next lower support which would be DOW 9800. Not defending DOW 10,200 turned out to be the right move as more bad news on Europe (Hungary) weakened the Euro again and very disappointing US unemployment combined to draw heavy selling which would have made DOW 10,200 history anyway.

To give credibility to my theory that the PPT purposely chose not to defend the 10,200 support in order to save bullets and fall back to defend 9800 would be to see it happen. Lo and behold yesterday, Tuesday June 8^th the DOW traded down to 9800 and even dipped below that level. A close below 9800 would be a very bearish sign. The DOW was below 9800 as late as 2:30pm before the run started. Further, we added another 80+ points onto the DOW after 3:30pm.

Suddenly, we have a bullish bounce off  a support instead of a bearish breakdown through the support. Moreover, that little 80+ point run from 3:30pm on created a bullish engulfing candle which is an even more bullish sign. It was so very convenient that the market, for no reason by the way, was able to add just enough points in the last 30 minutes to create a bullish engulfing candle to add to the bounce off 9800 support. According to my good friend David Elliott of Wall Street Teachers, this pattern which combines a bounce off a support with a bullish engulfing candle is very bullish……one of David’s more favorite bullish indicators.

Coincidence……..NO WAY!!!!!  It was the PPT !!!!

PPT as a Technical Indicator

Back on Friday, May 28^th, I mentioned that I was surprised to see that the PPT had not jumped in at the end of the day to rally a down market and goose the DOW back over its 10,200 support level that it had violated earlier in the day. For a year and a half, the PPT had gone out of the way to try to eliminate and/or neutralize any negative or bearish signals. Here, they would have had an easy time accomplishing their task.

The ease of moving the market on Friday, May 28^th was due to the fact that it was the Friday of Memorial Day weekend and most of Wall Street was on the highways that lead to the beaches in the North East of the United States. This would lead to an illiquid market and allow an institution the size of the PPT to easily move the market. The time was right, the situation was perfect; yet the PPT did not move. They allowed the market to close below the 10,200 support! They allowed the bearish signal!

But why would they do that. They have jumped in so much over the course of the last year and a half it made me question the fact that they chose not to jump in. Did they know something a week ago that we did not know? Were they aware of the coming negative economic news that was to come out on last Friday namely the very disappointing unemployment report? Could they have possibly known about the negative news out of Europe? Maybe they knew about both!

This may be why they did not jump in as we would have expected. Maybe they decided to pull back and defend another level which would have been DOW 9800 (which the market did bounce off during the week). Obviously, they did what they did, or more specifically did NOT do what they did NOT do for a reason.

Many people have used the PPT’s action as a buy signal because of the frequency and predictability of their actions. The PPT buys and runs the market up to eliminate obvious sell signals. Investors and traders can buy along and go for the ride! Maybe, what these people need to start doing now is to use the PPT’s lack of action at obvious and expected times as a sell signal!

On Friday’s Action

I will be honest with you; Friday’s action spooked me a little. After a good strong bounce off DOW 9800 earlier in the week, the market had a monster day on Thursday taking the DOW to a close over an important 10,200 level. So, going into Friday, a holiday weekend Friday, there were some things I was expecting out of the day.

First, I was expecting a morning sell-off as is traditional with a counter-trend Friday. What I mean by “counter-trend” Friday is a Friday of a week where we have had a strong directional move followed by Friday where the market trades in the opposite direction of the weekly trend. This is mainly due to profit taking before the weekend. Those who have profited from the move during the week lock in their profits so that they do not have exposure to what can happen during the weekend while the market is closed. They do this because there will be two days of potential news while the market is closed and they can’t react to any news that may come out. This is especially true of long holiday weekends where a third day off is included like Memorial Day Weekend.

So, I was expecting a morning sell-off that would last through lunch……which we got! From there, what I expected and what actually happened differed greatly. You see, on these long holiday weekends in the summer, Wall Street tries to get a jump on the traffic heading to the beaches. Once lunch time arrives, traders have normally closed down their positions from the week thereby neutralizing their exposure and having a clear conscience for the weekend!

Now, after lunch, many traders head for the beach. Many firms are staffed with skeleton crews as most firms have trimmed their positions and exposures greatly.  With all of these traders on the roads the market’s liquidity thins dramatically. At this moment, the market can be influenced to move in either direction without a heck of a lot effort or resistance. This means that any major institution (specifically the US government through the PPT…..Plunge Protection Team) can move the market to fit their agenda very easily. At this moment, it would not take much volume to move the market thus not a lot of money…..a good thing for those wishing to manipulate the market.

I had expected that the sell-off would take us to a level below the 10200 DOW support. But, I was pretty certain that with a very illiquid afternoon, the PPT would be able to run the market back up over 10200 thereby nullifying the potential technical breakdown as they have done so many times over the last year.  As a matter of fact, the PPT has moved to eliminate so many bearish technical signals over this historic bullish run to prevent potential sell-offs that I have come to view it as an expected, common place event. This type of late day heroic rally was happening so often that many had even started trading it!

So, back in the day when intervention was so rare, so infrequent to the point of almost unheard of, government action could never be expected…..certainly not enough to be considered a trading signal! But today, intervention has given way to manipulation as the government is in the markets almost every day. So, when Friday afternoon came along with the DOW down below 10200 which would be a pretty bearish sign if it closed down there, I was almost certain that we would get a late day run to close back over 10,200. After all, with everyone at the beach, it would be almost too easy for the PPT to do it and once again erase that bearish signal. But alas, the day end rally never came. The fact that it didn’t comes as a pretty large surprise to me. So large in fact that I think it smells fishy.  The PPT has jumped in when the risk and dollars needed to move the market was so much greater! This should have been a layup for them. But, they remained silent and on the sideline at a most unexpected time. I wonder if they are trying to tell me something?