Sunday, April 09, 2006

Now, THIS is Exciting!

Awesome wipeout last Friday. At the risk of going out on a limb, I have to say that I am tingling with excitement about this (S&P) market. Here's why:
  1. We made multi-year highs and sold off.
  2. We then re-tested the highs and sold off again, HARD.
  3. Looks like a double top, doesn't it? Better yet, a double top with a massive headfake (we fail the breakout)?
So, given this context, what's next?

Well, keep in mind that I am bullish about the market overall. In fact I still very much think that it is heading quite a bit higher. Given this bias, there are two very profitable ways to play this setup:
  1. Wait for the market to sell off more and watch for OEX approach 580. As it get closer (preferably in a single day) start buying May ATM calls. It the weather gets really bad I can see the index dropping as low as 570. In that event you will be cost averaging calls and will end up with a whole load of them at that overextended level. Naturally, I fully expect the market to correct up and head higher from there. If I am wrong, blowing out of those calls will be painful but not at all destructive (assuming you use a decent allocation strategy): remember that the lower the underlying goes, the slower the price of calls will decrease.
  2. If the market does not sell off and rallies instead, wait for OEX to close (it really must close, not just trade) above 592. Once it does, you'll get long delta from there on. This is a less risky (actually, not less risky, but defintiely less gut-wrenching) play but it is also less profitable as your upside will be limited and you won't have the opportunty to accumulate size (unless you go all in right away). I am planning to position our fund net long SPY stock in this scenario.
Finally, if I am dead wrong and the market tanks and never looks back we'll have a great opportunity on the short side after an inevitable rally. But, we'll cross that bridge when we get to it.



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