Friday, May 19, 2006

1987 - Learn and Live.

I'll bet that this week every serious trader is scrambling for historial charts. More and more so with every down day. The news is out, it's bad (even though we all "knew" this all along and it's not really news) and we no longer care because the "fundamentals" are known and priced in. We now just want to know what the hell to do next.

A corollary to the above could be that spotting market bottoms can be made easier by correlating load levels on historical tick servers to severe price action. I'd love to run a study on this if I could.

As our readers know our fund is quite long in this market via long calls and short puts across several sectors. Short puts are not bad at all; granted, some spreads are in the money but on those we want the stock anyway.

Long calls is a different scenario. We're huge on NDX and a basket of issues in several sectors. We're getting huger as our models tell us to do. And in general, looking at the technicals that's the only way I know how to trade this.

As I type this Marty Schwartz's quote from "Market Wizards" comes to my mind. When asked what he would do differently in the crash of 1987 if it ever came again, he responded (I am paraphrasing): "Nothing. The market was way oversold and the only way to trade it was to get long." Then he proceeded to lose a sizable fortune.

At the bottom of the crash he then recovered and made a larger fortune.
There is a lesson in this. Both in 1987 crash and Marty's trading.

The S&P right now (or as of last night) looks strikingly similar to how t looked in 1987. Same sort of right-off-the-top, relentless action that made the market look very oversold right near support levels. All of that happened during the expiration week preceding October 19th. Friday's down bar looks huge and even though I don't have volume data I can tell that it was a "blow-off" looking day. I'll bet a lot of people bought into that one. Marty did. And, the way I trade, I would too.

At that point the market was off almost 50 S&P points off its nearest peak in a non-stop free fall. We all know what happened on Monday. Specifically, the S&P fell an additional 60 points and ticked a few points below longer term (two year) support levels. Following this crash a rally of about 40 points followed.

Today, the S&P is off about 60 points in the same fashion as back in 1987 and we are near support levels. We haven't had a big blow-off day but the volume on 5/17 was double the norm so maybe that can qualify. At any rate, there is a clear possibility of a much larger decline dead ahead and if 1987 is any model then an aditional 60-70 point drop is possible. That takes us to 1170-1180 level which happens to be a significant support level.

By the way, I am using 1987 in nominal terms, not percentages. That may be wrong, but I am looking at what's similar about the markets. The scenario of 1987 is technically fitting and that's how I choose to look at it.

Now, we are surely not betting on a crash (see above), but we are very cognizant of that possibility. The way we're playing this is the following:
  1. We are long and getting longer, but only to a point. I do think the probaility of a reversal is very high and we'll have a big spike up after the reversal. That's basically why we're long now.
  2. If the market decides to crash then I suspect that 1170-1180 levels will be a zone of a massive buying pressure where it will be necessary to buy a highly leveraged position. I think the bounce there will be fast and agressive, followed by more downlegs. All of them will be buyable, even if new lows are made with every move down. What we intend to do is get a large futures position right after the open with intent to blow out of it after the immediate rally. Then, smaller portions will be averaged down on every move lower to accumulate a core position to capture a more sustained move higher.
If (2) happens it won't be pretty and large losses will occur. However, these same losses will spell a much larger opportunity and that's why powder must be kept dry for that occurrence.

Make no mistake, this is hard. So, prepare for a bloody one.

Cheers,
/Dmitry

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