Tuesday, May 8, 2012

Air Pockets

Open most histories of the stock market crash of 1929, and your eyes will eventually come across the phrase "air pockets", referring to sudden and unexpected whooshes downward by stocks that quickly recovered, but that left traders increasingly nervous.

The phrase was much used in discussion of the market prior to the crash.

I am not in any way predicting a new 1929-style crash. Markets today aren't the markets then. Stocks exist in a totally different universe than they did eight decades ago.

But, I think a case can be made that we're in a market environment that is filled with air pockets. And like the traders of 1929, it makes me nervous.

Case in point. Zacks added 50 stocks to its top-buy list today. The list is based on a compilation of analyst opinion. So these are stocks that analysts think well of.

As of this writing, about 1 p.m. Eastern, 26 of those stocks are down more than 1% from the prior day's close. Nine of them are down more than 3%, and three are down more than 7%.

Nineteen stocks out of the 50 are showing intra-day declines.

I started work today with the full intention of analyzing two stocks -- the most bullish charts from yesterday and today.

Yesterday's top pick, Whole Foods Market (WFM), is down 1.8% from yesterday's close. It is one of 21 stocks, out of 38 added to the Zacks top-buy list, to be down more than 1% so far today.

The S&P 500, which showed a lower low -- the start of a downtrend -- in futures trading on Sunday, made it official on the index today by dropping to 1347.75, so far. (See my discussion Monday of the after-hours low.)

On the index chart, the swing high is 1422.38 on April 2, the first correction low is 1357.38 on April 10, the lower high is 1415.32 on May 1, and the lower low today is at the least 1347.75.

It's an extremely clear pattern, with no ambiguity.

Yet it is early days still. One of my mentors in trading was fond of saying, "One day does not a trend make."

Bottom line: I'm not doing chart scans or analyses until I understand the trend the better. I mean, there's no point. I'm certainly not going to open a new bull position in this market. I'm keeping my focus on mitigating the damage.

For the future, if the downtrend continues then I'll need to switch to analyzing bearish stocks. That's not my favorite way of trading, by far. Bearish trades are limited to stocks having options or to short sales, which have a carrying charge.

Also, a falling stock suggests that there are problems within the company, and companies with problems sometimes fail, taking their stocks and options with them down to zero. I've had that happen to me once. Thank you, PSI. Never again.

Absent a working crystal ball, the smart trader follows the market. And that I shall do, when I understand more clearly what path I'm following.

Long term, on the weekly chart, the S&P 500 remains in an uptrend. It would take a decline below  1074.77, a level set last October, to indicate a downtrend in the making. 

That would be a 24% decline from the swing high, and I think all traders would have headed for the lifeboats long before, leaving only the buy-and-hold 401(k) and IRA crowd to go down with the ship.

For my own account, I've been reducing my theta negative positions. These are options spreads whose value is eroded by the passage of time. Examples of such spreads are long vertical spreads, such as bull call spreads and bear put spreads. 

My theta positive positions, which gain value with the passage of time, remain in place. 

My diagonal spreads, which work much like covered calls, remain in place. These sorts of constructions have a short component which is theta positive and which expires within a month, and a long component which is theta negative and which expires six months or so out in the case of a new diagonal spread, or which never expires in the case of a covered call.

The long components of my diagonal spreads were all insured when they were opened as I bought out-of-the-money covered puts, and are protected further by the premiums earned from selling the short components.

So my diagonal spreads will remain in place for now.

Note: In this discussion, "yesterday" refers to Monday, May 7.

I screened the stocks using a tourney bracket with a one-month daily chart and a three-day half-hour chart, and then turned to a five-year weekly chart for the broad context in analyzing the bracket winner. See my essay "10,000 Charts" for a discussion of my screening methods.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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