As serious investors, monitoring the market cycle is a basic element of our ability to ‘time’ my investing activities. In fact, William J. O’Neil claims that sharpening this saw is the most important activity any investor can engage in. He calls this the “M” in his seven step due diligence process. Why is this so important?
It is generally accepted that seventy to eighty percent of all equities follow the general market. A mental image of a marina helps me to appreciate this concept. When the tide goes out all boats will drop, while they will rise in unison when the tide comes in.
The U.S. market recently enjoyed a full quarter of bullishness. Selling pressure entered the market at the end of March and our current correction took root in early April. Is this the time to go all-out-bearish? It Depends!
The following elements and behaviors that can be monitored to help us see the difference between a healthy pull back and the start of a new bear market.
- · What does the selling feel like?
- · Where are the closes of the indexes?
- · What are the leading stocks doing?
- · Are there any negative or positive reversals?
The psychology of the sell-off in the market can be seen in the volume and price changes from day to day. Heavy volume with a drastic drop in the price of a major index is an obvious ‘tell’ that investors and fund managers are fleeing in mass. Is this a one-day event? Or does it persist?
Is the closing price of the index at the low point of the day, or above the midpoint between the intraday high and low? When the closing price is in the upper half of the daily range, that’s evidence that much of the volume was due to buyers picking up shares at a discount price.
Which stocks have enjoyed the biggest gains in the bullish move up? Are they remaining strong during the market correction, or selling off aggressively? Follow the leader!
The negative or positive reversals are another way of monitoring the price/volume action. Usually they’re a result of news being introduced during the trading day. That news could cause a temporary knee-jerk reaction, or it could be the beginning of a series of consequences that affect the market fundamentals in the weeks to come.
So, what does THIS market correction seem to be telling us? Selling has been strong on only one day during the correction, so far. More closing bars have demonstrated resilience by closing off the lows of the day. There have been very few casualties among the leading stocks. And reversals have shown little significance, too.
There are several potential strategies to use during a mild market correction as described above. One choice might be a Put Calendar. Why? Because this can be approached as a short-to-medium term trading strategy with minimal risk. Nobody really knows how long this correction will last.
EQUITY CANDIDATE: An equity demonstrating some strength yet has stalled on its price increase due to the market environment.
EXPECTATION: Stagnant to Mildly Bearish.
INSTRUMENTS: Near term Short Put (May 2012) plus longer term Long Put (at least two months out from the short put expiration date: (July 2012)
RATIONALE: The difference in the rate of decay of options is the key to success. Whereas both instruments are placed at the SAME STRIKE PRICE, slightly out of the money, the long put will hold its value better than the short put, leaving an overall profit in the trade upon the expiration of the short put ‘worthless’ (out of the money.)
RISK: Because the Long Put gives the buyer the RIGHT to sell the stock at the strike price, and the Short Put comes with an OBLIGATION to buy the equity at the strike price, the full risk is only the Net Debit in the trade.
Keep your eye on the market environment. That will be your guide to strategy choice. And remember: Even five-star athletes need to rest at times!