The Long-Term Trader

As promised, and after a lengthy absence, I am writing a weekly (or monthly) column on how to use market indicators and clues to help determine market direction. Here is this week’s column ( http://goo.gl/CzYnLd ):

One of the most important skills traders learn is how to decipher clues as to the market environment. Even if you are trading individual stocks, it is essential to be aware of the overall market. Such clues can help determine whether you should move to the sidelines in cash, buy on the dip, or use short-selling strategies. 

Here are several market clues I’ve recently observed: 

1. MarketWatch columnist Mark Hulbert recently wrote an insightful column highlighting the Hulbert Nasdaq Newsletter Sentiment Index (HNNSI). This is a contrarian indicator: when the HNNSI plunges, and sentiment is pessimistic, it’s bullish. When the HNNSI soars and sentiment is overly optimistic, it’s bearish. Currently, Hulbert notes, “the HNNSI stands at 77.8%, more than 130 percentage points higher than it was three weeks ago.” Accordingly, Hulbert says, the odds of a coming market pullback or plunge are higher. 

2. In addition to the HNNSI, the Investors Intelligence (II) sentiment survey is currently at 54.4% bullish vs. 24.7% bearish (as of July 19), which confirms Hulbert’s sentiment gauge. Bottom line: The crowd is overly bullish, and that usually does not end well. (In addition, the American Association of Individual Investors (AAII) sentiment survey is also bullish: 35.4% bullish vs 26.7% bearish as of July 20.)

3. Volatility has collapsed to levels not seen since before the previous plunge. The CBOE Volatility Index VIX, +0.70%  is currently around 12.0. Such a low point for the VIX suggests that investors have little fear of a market selloff. When volatility is this low, it is best for traders to stay on the sidelines (especially if you are trading index options). 

4. Longtime market observers say that computer algorithms appear to be artificially boosting stock prices. For months, whenever the market sells off, a massive algorithm consistently buys S&P futures contracts on every dip. Some believe the Fed is behind such a massive buying program, but there is no evidence so far. 

What’s evident is that a entity with unlimited resources is buying on every dip (and also spiking the S&P futures around 2:30 a.m. ET each trading day). The result is that volatility has been crushed, as reflected in the low VIX levels. Even on small pullbacks, volatility is reduced and a buy-the-dips program stops the retreat. 

5. The one-year return for the S&P 500 SPX, -0.30%  is around 1.75%. Although thebulls are giddy , the facts are that the market has gone nowhere in the last year, even though U.S. stocks are at all-time highs. Put another way, the market has tried multiple times to break out of this long sideways trend but has barely made headway. 

6. Well-known market experts including Carl Icahn, George Soros, Stanley Druckenmiller, Jeffrey Gundlach, and Larry Fink are advising investors to either get into cash or go short, and this cautionary advice gets little or no respect. 

7. A three-month chart of the S&P 500 shows that the market has been in a slow-motion melt up since the Brexit lows (a 9% surge). Some individual stocks are at nosebleed prices with long-term RSI levels of 100. Many technical signals appear broken, which is why many traders believe the market is being manipulated. 

8. Finally, although the market is making new highs, volume has been declining, which is a huge red flag. Lance Roberts discusses the dangers of low volume and central bank intervention in his Real Investment Advice blog . His advice: Take profits from the recent advance sooner than later. 

Based on the above clues, it appears that a short-term U.S. market top has formed. Although it is tempting to short the perceived top, it is too dangerous to do so. After all, the market could still go higher from here, creating a more extreme market melt-up. If some investors are afraid of missing out, shorts will continue to get shredded. 

Instead, it’s prudent to wait to see how the market reacts at these overbought levels. If the bulls are right, the market will push higher. But given past market behavior, the danger signs are everywhere. 

The following column written by me was posted on MarketWatch (http://goo.gl/zAgsUc):

Welcome to Brexit week. The U.K. is voting to stay in the European Union or leave, and global market volatility is expected to increase before and after the June 23 Brexit referendum. It should be a wild week for the markets. But for most investors, the odds of making money are probably better at a casino than trying to pick winning or losing Brexit stocks. 

Rather than choosing individual stocks, there is an options strategy you can use to potentially profit from Brexit: the straddle. When you buy a straddle, you simultaneously buy a call and a put using the same strike price and expiration. This intermediate strategy can bring potential profits no matter which direction the market moves. The caveat: It works only if the market makes a good-sized move in either direction, up or down. 

Although this strategy sounds too good to be true, like any options strategy, there are of course specific risks. For option traders willing to take a chance to make many times their investment with limited risk, buying straddles is one way to profit.  

Low inflation, high volatility, and an overvalued stock market pose risks for investors, but those challenges also bring opportunities, say the experts at a MarketWatch panel discussion in London.

The ideal market environment for buying straddles is just before a market-moving event, such as a Fed meeting, an earnings report, or a momentous financial event such as Brexit. No one can predict whether the market will rally or drop once the U.K. news is announced. There is also the possibility that the market will give a big yawn and ignore the decision. By buying a straddle, you are speculating that there will be a large enough price change (up or down) to more than cover the cost of the straddle. You don’t care in which direction the market moves, so long as it moves. 

To initiate a straddle, you will buy a straddle on the SPDR S&P 500 ETF, SPY, +1.22% . To reduce risk, I recommend that you limit the number of contracts you buy, especially if you are inexperienced. 

For example, on Friday you could have bought a straddle on SPY 206 July 15 (1 put and 1 call) and paid $7.67 (the July 15 call was $4.00 and the July 15 put was $3.67; total cost was $7.67, but that price will have changed by the time you read this). This trade would cost $767 for one, 100-share straddle, $1,534 for 2 straddles, and $3,835 for 5 straddles (plus commission). Typically, you will buy a straddle with an at-the-money strike price (i.e. the strike price is near the SPY price). 

One of the risks when making this trade is that implied volatility is expected to increase as Brexit approaches (implied volatility rises with anticipation and anxiety). This will push option prices much higher. In fact, one of the risks of this strategy is that you may overpay for the straddle. If you do overpay, you could still lose money even if the S&P 500 makes a fairly large move. 

If you do make this trade, use a nearby expiration date. Most importantly, under no circumstances should you hold either the call or the put until the expiration date. 

To reduce losses and lock in gains, sell both legs (call and put) within hours of the Brexit announcement, and definitely by the end of that day. In other words, sell the straddle once the news is known and the stock market has reacted. Time is your enemy when buying straddles, which is why you must sell quickly. You may choose to hold for several hours if you believe SPY will continue moving in the same direction during the day. Theoretically, the profit potential is unlimited for the life of the option, but in real life you will take your profits, if any, before the end of the day. 

The most you can lose on this trade is the initial amount paid for the straddle. You will lose the maximum only if you hold until expiration and SPY is still at or near $206 on the expiration date. 

Again, do not hold this straddle over the coming weekend, “hoping” you will make more money. That’s how traders watch profitable option positions turn to dust. Option traders rely on good odds, not hope. 

Michael Sincere (michaelsincere.com) is author of “Understanding Options 2E” and “Understanding Stocks 2E.” The above examples are not recommendations to buy or sell options. If you have never traded options before, practice trading before putting real money on the line. Follow Sincere on Twitter: @michaelsincere

Because the S&P 500 fell below its 50-day moving average, and the MACD line crossed below the 9-day signal line, and could fall below the zero line, it’s time to pay attention. It’s not just the indicators that are signaling trouble. The dollar is rising (which pressures stocks), earnings were terrible, and the low-volatile market is struggling to gain traction. We will know more within the next two weeks or so, but it appears as if the market is setting up for a pullback. 

I have learned the hard way that it’s wiser to be a little late when buying (which is why I like probes). As I wrote in my latest MarketWatch column, when the market is going sideways, stay on the sidelines or probe with smaller share size or fewer option contracts. Actually, the market is starting to drift downward, and if it keeps falling, we could see a major pullback (my experienced technician friends say that if the S&P drops below 2030, look out below). 

However, as you’ve seen before, any pullback could be stopped in its tracks with a few words from the Fed (i.e. “We are not going to raise interest rates…”). Unless real fear hits the market, we could go in either direction over the next two weeks. In my opinion, the odds favor a downtrend, but it’s not a 75% probability. Therefore, it’s best to wait, watch, and probe. When a pivot point is finally confirmed, it could be “snapping time.” Until then, be patient, and be on guard. The market is starting to get interesting again. 

Although complacency is at an all time high (and the VIX at an all-time low), a credit event appears to be looming. This means that certain companies may have cash flow problems. Keep your eye on those deteriorating CCC high yield bonds, and read my MarketWatch article (below). The market climbed 13% in a month and many are saying the market will never go down again. This is what they say at the bottom, but with an opposite prediction. 

Bottom line: This is the time to get defensive, and if you are aggressive, start building those short positions. Hint: Buying puts is less risky than shorting, and if you are wrong, you know in advance how much you can lose.

Note: If this credit event is for real, even the Fed will be unable to contain the damage (but they will try).