Friday: Not What You Expected?

Well, not exactly what we expected either. From one point of view, Friday was a great day of respite - our long call positions got better and our short put positions got more chance to remain profitable. From another - I really thought we'd get a negative day with a Monday follow-through that would create a blow-off bottom.

Since this didn't happen, I think things may be worse than I originally imagined.

Naturally, I am going out on a limb here, but since the markets did not continue the bleeding it may mean that we're in the kind of a steady downtrend that doesn't get anyone excited but does get everyone very frustrated. This is the worst type of action - especially for the newer players as they are very prone to be stopped out on every rally.

As a trader, I like quick, stabbing sort of action that creates visible probability pockets. A slow grind is a mind killer and a bore, but more importantly, it is much more dangerous than a fast, bloody (or peachy, depending on whether you ever look at your charts upside down) move that culminates in opportunity-generating agony. Slow, grinding trends tend to last until everyone throws in a towel and by the virtue of being slow, the "towel" event takes a bit of time to occur.

Now, regardless of the type of action, the probability of Q's breaking through 40 remains unchanged and if anything, any coming rallies should be used for sizing your positions bigger. Having said that, the context of this trend dictates that it is important not to chase any prices - all moves lower have been showing to reverse quickly and if you don't realize this, your short positions will cost you a lot more than it should.
And if they cost you more, then you may not be able to afford to be wrong as is often neccessary.

As far as what our fund is actually doing in respect to the Nasdaq and our favorite market sectors, I'll post an update this weekend. Until then, enjoy the early spring weather!

Cheers,
/Dmitry

QQQQ Taking Aim at 40

Here is a trade that's in the cards: QQQQ should break through 40 wthin the next few days with a very high certainty. Are we betting this way? Most certainly - a good portion of our fund's money is parked in long April 41 puts. If we get another rally, we'll park more.

Why are we so certain?

Two reasons really:

1. Technically, the market is developing a severe downtrend which is currently in the midst of making. It is being confirmed by many sectors and many other markets.
2. More importantly, breaking below 40 will complete a much-awaited head-and-shoulders pattern. Just so you know I personally don't believe in this pattern (or most others for that matter). That's why I think the pattern will in fact occur - I've witnessed this sort of self-fulfilling prophecy ( this sounded far too much like a cliche but I had no better way of saying it) far too many times. That's also why I think that covering our short positions right below 40 will be the perfect trade.
   

In sum, I think NDX-100 is heading lower, but will it reach a new decision point above 1600 level. As far as I am concerned, QQQQ @ 39.75 or so constitutes a point of a random outcome. To make this perfectly clear, right now the action is non-random and should be traded with proper odds built into your risk management. Below 40, all aforementioned probabilities get thrown out of the window and a new game begins.

Before my readers point out that I am contradicting myself (I did say a "severe downtrend" above) which can't possibly imply a mere 1 point of decline in the Q's, understand that I am only talking about the probability of an impending break below 40. Given the context, my read is that this probability is in high 80's. However, after it plays out, future moves will have a different probability profile. - dictated by the function factoring the magnitude of the decline and elapsed time.

Today, I don't care about the future that far out. But in a few days I will.

Cheers,
/Dmitry

Housing, Gold and Oil, Redux

A few notable things this afternoon:

One, the Nasdaq-100 stalled after the 25 point rally (from yesterday's low to this morning's 10 am reversal) and sold off. The painfully obvious level of resistance is 1672. The reson I say "painfully" is that such obvious levels rarely work outright. However, the reason I am pointing this level out is that this time I think it really is important and needs to "work" in order for the down leg to continue. If we close significantly above it, I will scale back on our bearish positions.

Two, Housing is looking worse than ever. Even the rally barely helped. With RYL breaking 65, BZH breaking 60 and CTX free-falling towards 60, this sector looks so oversold that regardless of me being right or wrong in the end, the only way to play it here is to aggressively get long calls. We're already long in KBH and a few other names, but here's where we're going to get longer.

Three, Gold bounced as expected and now we're scratcing our heads as to whether to use this rally to get short outright. Not enough evidence here but do stay tuned. I think the best outcome for this commodity is to move sideways as I suggested a couple of weeks earlier. I doubt it's got upside right here, right now. So, why not sell calls? Because, the short signal that's in place now may get rejected, and if it does, we'll get the kind of a rally that negates all of the above. So, back to scratching heads. (Isn't being a trader fun? :)

Finally, Oil is acting as expected. Selling April call premium here looks right.

Cheers,
/Dmitry

World Markets Top?

I am not an expert on macro views as far as the world's markets are concerned, but poring over my charts tonight I saw something that stood out like a sore thumb:

Indices around the world don't look so good. The indices I am talking about are represented by listed funds (ETF's) on Amex and Nyse. These funds concern the new "leading emerging" economies - the spotlight of economic developments and, if I may say, "precipitous" hype:

• India: IFN
• Russia: TRF
• China: FXI
• Brazil: BZF
• Turkey: TKF
• Japan: ITF

The notable thing about all these tradeable funds is that not only they just appear to be "toppy", but that most of them (with exeption of Japan) present very prominent tops followed by two down days with an expanded range and an unusually high volume (in some cases volume was almost triple the 10 day SMA). To me, this looks like an ominous combination, even though I don't see much of a catalyst behind it.

But then again, most events never have catalysts - until after they occur.

What to make of it? Well, as I mentioned, I am not an expert on foreign markets but this does look like some sort of a top with possibly worse things to come. Some of these tops show strong sell signals on a longer term scale, and as I look at them I get a familiar feeling of "have-to-get-short-now-don't-care-how", which usually resulted in profts. Having said that, please be careful to not read this as a deliberate forecast of some doom and gloom scenario - I am merely pointing out something that may "click" when you witness a seemingly unrelated situation in the US markets. Given the proliferation of foreign influence on our market indices, the globe is really worth paying attention to (it always has been, but now it's simply a must)

The way I am advising our fund to game this is to continue the mode of selling rallies in the broad indices. If anything, the above gives me a stronger (or more confident) bearish bias, which will be parlayed into our trading.

It's odd. I am not a forecaster and I (mostly) don't believe in it. Most of the things we trade seem to show a trend of anywhere between "blah" and "bad", and if I had to get on CNBC and try to make a "prediction" I'd have absolutely nothing good to say, except that the VIX will probably be a lot higher in the coming months.

All of this may well amount to nothing, but my gut tells me it does. So, I advise to keep this in mind, trade accordingly and hope that the bottom does not fall out.

Bad things happen when it does.

Cheers,
/Dmitry

Sell the Rally, Buy the Break

That's the name of the game as we see it. So far our scenario of Oil, Housing and Gold finding short term bottoms is panning out as expected. At the same time, rallies in the Nasdaq are presenting opportunities to get bigger on the short side.

• Oil: Most of our names have bounced (we're looking to liquidate long calls) and the put spreads collapsed. Now we are looking to sell call verticals on this upswing. Oil spot looks oversold and I do think more upside is in the cards.
• Housing: Less of a bounce as I am seeing more names reaching oversold condition. I do think we'll see a tradeable rally here as well. Leaning long calls as the sector grinds lower.
• Gold: Spot looks terrible. Technically, there is a MASSIVE sell signal in place. Yes, it looks that bad. However, equities seem to have priced in a substatial drop in the spot and are near their short term bottoms. Leaning calls here as well.

My order of short-term bullishness on these three sectors is: Oil, Housing, Gold.
At the same time, Oil and Housing are in longer term downtrends with Gold at a big decision point. Watch the Gold futures very carefully here - I can't bring myself to get short, but the indications are definitely telling me to do so. (Am I a gold bug?)

Biotech is also bouncing smartly but I haven't figured out my stance on it. I am putting Cadence money is BBH and separate names fading directional moves.

Finally, Metal Miners look terrible and that tells me that buying vol is a good idea. We're eyeing CCJ as an interesting candidate. At the same time, PD and CLF look close to a near-term bottom and we're selling put verticals here.

Caveat: I just re-read all of the above and it feels like a hodge-podge of trading ideas. Well, it truthfully is. There is a lot going on and I owe it to our fund to not leave anything on the table.

When markets move we have to trade them. That's what we do.

Cheers,
/Dmitry

Heavy Metal

In the midst of all this action I almost overlooked the Metal Miners sector. First off, I absolutely love the volatility here. At 45 vol underperforming realized volatility in major names (PD, CLF, PCU, etc) we can be buying April premium to take advantage of the oversold condition and sell near-term premium because with downside becoming more and more limited it is so darn overpriced. (Yes, I did say overpriced, even though implied vol is actually below statistical)

So, we're selling CLF March 80 puts and looking to buy April 80 calls once the stock trades lower. PD March 150 calls are similarly expensive and we are legging into short vertical with every uptick we get.

This is the sector to be aggressive on. Get in there and trade it.

Cheers,
/Dmitry

Action: Oil, Gold, Housing, Biotech

Listless action in the indices. Even though I always heed the old saying "don't short a dead market", I read today as bearish. Reason: if yesterday's drop was unimportant then I fully expect it to be bought aggressively. Well, so far today is anything but aggressive.

We did not add to our short positions this morning as the rally we got was just ... small. Instead, we'll either expect a stronger rally or just wait to cover lower. It's just me - often I can't stand to add to winning positions. Something to ponder. Glad I don't make all the trading decisions! :)

Now, other sectors are moving nicely with Housing, and Oil hitting oversold levels.

• In Housing we're leaning long calls in KBH, RYL and BZH. I do expect this sector to grind lower, so these puchases are initial position builders.
  
• Oil looks terrible and that tells us to sell OTM vertical put spreads. Basically we are legging into an "iron condor" position with short call spreads sold higher and puts spreads being sold lower. Names: HYDL, SFY, and of course, APC.
• Gold spot looks bad here but the stocks (NEM, ABX, AU) paint a different picture. NEM punched through 50 and we have a consensus that buying April 50 calls is a good thing with the stock trading below strike. We did miss a good entry at around 49.50 but I think we'll get another opportunity. Too many hands in the pot...
  
• Biotech BBH "breakout" was a headfake but I don't expect the Holders to break below 185 any time soon. Excellent premium there and we're selling it on downticks.

To sum it up, we are bottom fishing by either leaning long calls or selling overpriced put premium in these sectors. Note that there is considerable risk in doing this as short gamma exposure this close to expiration can get worse very quickly.

But risk has two sides. More on that later.

Chers,
/Dmitry

A Tick Lower

The markets ticked a bit lower (Nasdaq, Oil) with Gold a tick higher.

Look out for a rally this morning and if it does come, we should be able to add to our positions at around 10-10:30 am, when early reversals tend to occur. Personally, I would love to see a rally because down-down-down action gets oversold too fast.

Our stance is unchanged. Best of luck today.

Cheers,
/Dmitry

What We Are Doing

A quick recap of the day with some parting thoughts:

• I am putting a portion of our fund's money into QQQQ puts and NDX-100 credit verticals. I am becoming a bigger bear in this market and I am putting our money where my mouth is.
• We're doing similar things with Oil by selling more near-term verticals. However, I am also looking for overextended names to buy April calls. I do expect the action to grind lower with a tradeable snapback. Read my "Buy Premium!" article on how to game this.
• We are also deploying long calls (April) into the Housing sector. I like KBH the most out of the lot but I expect more long delta/vol exposure to be added to our books in other names as well. Not calling a bottom here (especially if SPX decides to collapse) but Housing, being as oversold as it is now, will be less vulnerable (almost overlooked) if things get bad.

That's all for today. For those wondering why I haven't said anything about RIMM, here is a quick answer: it's pure alpha and is really tough to game. We sold some puts on it but we have no serious commitment. However, if it moves above 85 (quickly) we'll be looking at it again.

Finally, I expect the market to uptick overnight and maybe try a rally tomorrow. If you're with me on this trade, you'll be selling it.

Remember to manage your risk. In the end, that's the only thing that will keep you alive.

Cheers,
/Dmitry

1666, The Number of the Beast

NDX-100 is at 1666 as of this writing. We're selling call verticals and holding on to our long puts on the Q's.

I fully expect this move to be faded by gamma scalpers in the very short term but it does look real once the program pressure is gone. If the scalpers do come in, use the uptick to size up.

Stay on your toes.

Cheers,
/Dmitry

Slick Top!

Our model tells us that we just saw a top in Oil. June contract reversed at 66 and our bet is, it's not going anywhere above it.

It's a big statement, I know.

At this time we're selling call verticals and looking to buy lower OTM calls after the leg takes us lower. No, I don't think it's Armageddon in the Oil market. In fact I still think that while we saw the top and we are ways off from the bottom, the action that gets us there will be volatile. If you're ready to hit the market like we are then play both ways with a negative bias.

If it sounds like I am talking from both sides of my mouth, I am. But recognize that I am an Oil bear and I will sell rallies and buy blowoffs - all while staying a bear. You want to trade the S&P and the Nasdaq? Fine, but as far as I am concerned Oil is THE market.

Get in there and trade it.

Cheers,
/Dmitry

What I Saw Last Week

Had I been a stock trader I would now be finding fewer and fewer things to buy long. In fact, in this low vol environment, owning index puts doesn't sound like such a terrible idea. My only problem: I didn't see enough of an extreme reading on the upside to start scooping them up.

However, I did see this: past Tuesday and Friday were down days for the broad indices. Notably, both days had an above average volume when compared to the other three days of the week (where the market ended higher). Plus, last Friday the market rallied within fractions of a multi-year high (SPX) and then reversed at around 2 PM to give all the gains back and close in the red.

So, whlie I am not reading an outright short signal I think the play is the following (let's take QQQQ as the vehicle):

Watch the 42 level and look for a close above it. If you can't wait for the close then get in on a retracement once it is punched through intra-day. Then make sure we close above it. My rationale here is that if the market indeed breaks through, it will reject two big-volume down days and will also reject Friday's reversal.

Now, if the weakness continues, then become a cub and start selling the rallies (via buying puts, for example) and grow to become a bear as the market guides lower. 42 becomes your stop loss point. Now in this case don't take "42" too literally. My point is that if you've seen enough reason to get short, you don't want the market to get even close to 42 because it will then mean that it's just not weak enough to continue selling.

Why buy puts and not short the Q's outright? You want to pick up the spike in VIX.

Cheers,
/Dmitry

P.S. BTW, if you still don't think that 42 is important, consider that 42 is the meaning of life, according to Douglas Adams.
:)

Buy Premium! (Part II)

In the first part of the article I talked about the virtues of buying options and expanded on employing volatility view as the basis for a long strategy.

While vol trading is a good reason to get long options, there are a few drawbacks:

1. Often you have to continuously flip stock against your long gamma. This creates non-negligible transaction costs.
2. Every time you flip the stock you have to make a decision to limit your profit running in one direction. That's a tough thing to do, time and again.
3. You often have to keep your positions on for many weeks so that your stock profits outrun the time decay of your long options. So, besides constantly having to trade around your position (that takes focus away from other things), you also have to commit your capital for extended periods.

In spite of these drawbacks, I still do vol trading all the time, but more often than not I look to buy options in order to capitalize on a highly probable directional outcome. Before I go into this let me state for the record that directional trading is a very tough game. In fact I think it is by far tougher than any other game in town.

Why is it tough?

• It's the most level playing field for traders. Everyone has pretty much the same level of access and thus, unless you are a specialist or an institution filling a massive order, there is no inherent edge available to anyone.
• Directional trading has been around for much longer than any other type. Thus every imaginable method has been developed and tried in every market that goes up and down. You have to assume that they were developed by a lot of very smart people who have tried very hard and then failed miserably. Notably, a few winners do stand alone. Very alone.
• The data needed to run strategies and evaluate new directional methods is readily available. The facilities needed to grind this data are equally ubiquitous. Again, no mystery there.
• There is more randomness in the evident directional moves that most traders choose to believe. That's their choice but the reality is that most of the time the markets are chaotic and have very low odds of showing a particular direction (the one that agrees with yours)

Other factors, too numerable to be listed, exist. The point is, if you're going to play this game, you'll need every imaginable advantage you can find.

My advantage is using options, and not the underlying, for directional positions. There are a lot of reasons for this but the two most important ones are below:

1. If you're long an option and you're wrong about the direction, you lose money at an ever slowing pace. This is due to delta curvature (gamma) where as the underlying moves away from you your delta exposure automatically drops off. So, if you started with an ATM call with 50 delta, you end up with 25 delta after a couple of points against you.
2. You can afford to be wrong. This is basically an elaboration of (1). Let's say you want to buy 10 calls. You know that being right at the time of purchase is unlikely. So, you buy 3 instead of 10. Then as you end up wrong, you buy more. Yes, you cost average. And here is why it's not an evil thing to do: you buy options at lower cost and with lower delta exposure. This last fact is crucial. The more and lower you buy, the slower is your rate of loss. And as your rate of losing slows down, your odds of making a profit on a reversal are increasing.

Caveat emptor: I have completely factored out time decay. I chose to discount it because I generally buy options with at least 10 weeks to expiration and my directional setups have an expectation of working (or not) within 5-7 trading days. Thus, theta is minimal.

Other reasons exist but, contrary to popular belief, are not nearly as key: the most frequently cited ones are limited risk and greater leverage.

Now, if you consider (1) and (2) carefully it is obvious that cost averaging should be done close to turning points of the underlying. Naturally, those points exist at substanstially extreme levels. Without giving too much away, let's quantify "substantially extreme":

1. Two or more standard deviations away from some average or mean.
2. Maximally short in terms of elapsed time.

These two points are not to be taken literally. They comprise the basis for the directional model that has a respectable level of probabilistic outcome. The actual parameters and numbers with respect to the magnitude of the move and the time factor depend on the underlying, the sector, the market and, ultimately, the trader.

Cheers,
Dmitry