Stock Prices are Still Walking a Tightrope

Stock Prices are Still Walking a Tightrope

Dear Slingshot Trader Subscribers, 

Note: Today’s weekly webinar will be held an hour later than our normal time, at 7:00 p.m. ET. If you are unable to attend the live session, the recording will be available later this evening on the Slingshot Trader website. As usual, we plan to discuss our trades (both open and closed) and how we are positioning for the coming week. We will also be answering your questions live, so don’t forget to attend.

Earlier this week, most analysts were expecting European labor and GDP results to set the tone for the rest of the month, and it was broadly assumed that the news was likely to be negative. The major stock indices were breaking support, and yields in sub-prime areas were rising. However, the news wasn’t bad (it wasn’t good either, but it was definitely better than expected). Germany didn’t dip into recession, and French employment was above expectations.

The market rallied initially on Tuesday after the news, but was unable to hold those gains. This kind of back and forth is frustrating, but not unexpected at a key support level like this. We still feel that the risk of a support break is high, but it could be delayed until after the weekend, when the G8 meets.

Commitment Levels Remain Low

There has been a lot said and written about the lack of volume during the October 2011 – March 2012 rally. That definitely indicates a lack of commitment to stocks in general, but it probably matters more to longer term investors, who may be holding a position for several months or more. Short-term traders have tried to deal with the lack of volume by maintaining a balance between bullish and bearish positions, and only shifting firmly in one direction or the other when the technicals point strongly that a breakout is likely.

In the next chart of the S&P 500, we have illustrated two reasons why short-term traders are continuing to shift towards a bearish outlook in the short term. The first reason is a Fibonacci retracement, where prices are sitting on the 23.6% support level for the third day in a row. In a ‘normal’ bull market, this is a potential layer of support. However, we think low levels of volume increases the odds that this support level will be broken, and have set a more aggressive target. If prices break lower, we would expect the 38.2% support level to serve as the next price target, which is not coincidentally equal to the highs from last October.

The second reason is an outline of the head and shoulders reversal pattern that has formed since February. This pattern is not nearly as large as the one that preceded the decline last August, but it is a big concern for bulls. A simple projection based on the height of the pattern would target prices just slightly above the 38.2% retracement level. That is also not much of a coincidence, as it is something we see regularly in patterns of this size.

chart1

S&P 500: Chart Courtesy of Metastock

The technicals are adding weight to the volume-based story that investors are just not willing to step into the market in numbers large enough to break prior highs. We aren’t forecasting the kind of problems that followed the U.S. Treasury debt downgrade last year, but the potential for lower prices or at least relatively flat trading is high. The bottom line is that the market is sitting at a potential breakout point, where it would take much less “effort” to push prices lower than it would take to attract buyers again.

Bear Markets and News-Based Trading

Bear markets (even short ones) aren’t the mirror image of bull markets in stocks, because volatility rises so quickly when prices drop. Bullish trends are easier to trade because options are less expensive, prices move a little slower, and trades can be held longer for larger profits. However, if the major indices do break lower, there are still profits to be made, as long as we are willing to make some tactical adjustments to our trading style.

Because bear trends move so quickly, and can often turn into V-reversals, like was saw in August, October, and November of 2011, its good to be prepared to exit a position a little faster than we might otherwise. Option prices will be higher and the bid/ask spread can get wide in a down market. This means that limit orders are critical, compared to market orders that are much more likely to be filled at prices that are not in our favor. Because bearish trends can reverse so quickly, we still need to emphasize a balanced portfolio of trades that integrates a few bullish positions with the larger number of bearish trades. Although our bias right now is relatively negative, it is worth the risk to buy a few calls along the way. 

The Bottom Line for This Week

There isn’t a lot of economic news due the rest of this week, and most of Europe will be out on holiday tomorrow, so we would not be surprised to see prices hover near the current range until Monday and Tuesday of next week. That could actually be good for us because it would hold implied volatility levels lower and give us more flexibility when we are getting in and out of our trades.

We also want to reiterate from last week that there is still a significant wild-card that could turn things around faster than we expect. It seems unlikely, but the last few times the European debt market has been disrupted, the Fed has stepped in and calmed things down. In late November 2011, they opened swap lines with banks in Europe and in September of 2011, they turned it around with the launch of operation twist – a bond buying program. The G8 is meeting this week, and it is possible that fiscal or monetary intervention could be announced. That could spin prices back up quickly, and we plan to be prepared to take action to profit from the news if it appears.

Here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.

May 17 – Philly Fed Manufacturing Index

May 17– Youku (YOKU) Quarterly Earnings – After Market

May 18 – Foot Locker (FL) Quarterly Earnings – Before Market

May 18 – G8 Meetings

May 22 – European consumer confidence

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via e-mail. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here.

Open Positions

These are the SlingShot Trader positions we opened during the past two weeks of trading that we have not yet closed.

Youku (YOKU) – On May 15 we recommended you to “buy to open” the June 22 puts for $1.80 or less. We still like this trade and recommend entries at our maximum price or less.

Foot Locker (FL) – On May 16 we recommended you to “buy to open” the June 28 puts for $1.10 per share or less. We still like this trade and recommend entries at our maximum price or less.

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

Chicos FAS (CHS) – On May 15 we recommended you to “sell to close” the June 14 puts. We closed the position for $0.26 per share for a loss of 63%.

Groupon (GRPN) – On May 14 we recommended you to “sell to close” the June 10 puts. We closed the position for $1.31 for a loss of 25%.

Silver Wheaton (SLW) – On May 14 we recommended you to “sell to close” the June 25 Puts for $1.35 per share for a gain of 75%.

Express Scripts (ESRX) – On May 11 we recommended you to “sell to close” the May 52.50 puts for $0.71 per share for a loss of -62%.

Nordstrom (JWN) – On May 11 we recommended you to “sell to close” the June 57.50 calls for $0.18 per share for a loss of 85%.

Webinar Preview: Join Us Tonight at 7 p.m. ET

Every Wednesday, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you’ll have live access to us for an hour every week.

And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at johnandwade@slingshot-trader.com.

If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.

Sincerely,

 

John Jagerson and Wade Hansen
Editors
SlingShot Trader