Sunday, March 12, 2006

Bearish Divergence

This isn't the first time I am seeing the Nasdaq and the Dow Jones present such differing reads of mass sentiment. While I can't exactly quantify why I think they are so different (aside from the generic 50 day MA point of view - one is below, the other is above, and the "lower lows vs. higher highs"), every time I've witnessed such divergence, the market corrected in a significant way.

By "significant" I mean more than just a couple of scary down days. Such diveregences have at least empirically shown themselves to be trend makers, where the resulting trends were negative and lasting.

That's pretty bad news because as I pointed out in my earlier post, broad downtrends tend to be slow, grinding and very frustrating... even to the bears.

So, what's a decent recipe for trading in such envornment? Pretty much what we've been doing all along: sell rallies and buy new lows. To most, selling rallies is fairly obvious. However, buying lows is only so to some. If buying a low in a downtrend feels "weird", I recommend reading my two-part article on buying premium for an idea of why buying in a downtrend can be a correct strategy.

Market sectors we're are presently focused on are the usual suspects:
  • Housing: we're seeing a short term retracement higher in an overall downtrend. Long call positions should get richer here. We have long delta exposure in this sector.
  • Oil: similar action with the smaller names (PTEN, GMXR) recovering much less than their bigger counterparts (SLB, APC, etc.). We're looking to sell more call premium into April.
  • Miners: undecided. Even though they seem to tag after Oil equities, I don't feel there is an edge there (minus the correlation). Watch this sector though as the vol has maintained healthy levels and a drastic move will get us long gamma in a second.
  • Gold: the stocks have bounced and even at their "bounced" levels they still look overdone. We have long call/short put exposure here but we are also short Gold June futures as I feel that the spot will do worse than the equities going forward.
  • Semiconductors: we're looking for the sector to grind lower as it is very correlated to the Nasdaq (I very much expect Q's to punch through 40). As SOX gets closer to the 480 level, selling put premium will become lucrative. At this point we're staying away.
Good luck next week everyone. Expiration time is upon us!



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