Buying and Selling Waves

This market does not make life easy, does it? What we would all prefer is some predictability about the action and a few reliable patterns that show us exactly where markets are going (more on that later).

It seems impossible to establish a rhythm to our trading/investing. We are unable to find the flow as markets go up and down. We often find ourselves facing north when we should be looking south, and vice versa. Unfortunately, our time frame as traders is often not the time frame of the markets, and that inevitably leads to frustration and disappointment. The market will do its thing, and we have to be ready to move.

From the previous highs in early July, the SPX 500 dropped about 80 handles (nearly 50 in about two days), and then it rallied up about 90 handles. All of that action occurred in about a month. If that doesn’t make your head spin out of control, then I don’t know what will! Could you have correctly been on both sides of the trade with your options trading strategies? The selling wave was sharp and swift, and volatility spiked as fear ran rampant., How does one react to that kind of speed?

Just two weeks ago, markets appeared headed for the danger zone – the SPX 500 was testing the 100 MA and closing in on the 200 MA (a long-standing bullish support area for institutional investors), and the 50 MA had just turned lower. The Dow Industrial’s tested that 200 MA and looked ready to break it. After all, it had been many months since price had met the average. The Russell 2K had already been flirting under the 200 MA for awhile and could not seem to get the ship righted after a steep drop from recent highs in early July.

Despite these signals and very oversold conditions, the markets came back with ferocity. The SPX 500 hit new all-time highs and was knocking on the door of 2K for the very first time. In fact, the SPX futures have rallied a stunning 100 handles in that time, a breathtaking 5.5% move up without much in the way of resistance. Along the way, a large group of stocks established strong price leadership and solid breadth, which was lacking during the last move to new highs in May and early July.

All of this illustrates that being in sync with the markets is nearly impossible on a regular basis. Just a small rumor of an attack in the Russia/Ukraine conflict can send stock futures into a tailspin. Who can prepare for that? We can always buy protection via index puts or going long on some volatility, but that won’t pay off on a regular basis, and in fact it has only worked well a couple of times this year.

Paying attention to signals, indicators, patterns and trends can help us become better aware of these waves, allowing us to position accordingly. For instance, say the McClellan Oscillator drops to extreme lows, there is a very high put/call ratio, the VIX spikes and sentiment polls turning bearish – the time is right to be a contrarian. If we don’t, the boat will tip over, as too many people are leaning heavily to one side of the boat.

This was exactly the case around August 7 and 8, when a slingshot move occurred that most did not expect. Now we have the opposite condition, with too many bullish people and indicators showing extreme conditions. In a bull market like this one, we can expect a quick correction.  Want to know how to prepare? Lighten up on your longs, and get ready for the next wave.