Jay Kaeppel, Optionetics.com
September 21, 2010
Back on 8/16/2010 I wrote an article titled “I Hope I’m Wrong” (http://www.optionetics.com/market/articles/23068). Well it appears that I’ve gotten my wish. Which is both a good thing and a bad thing. The gist of that article was that there seemed to be a possibility that the month of September was shaping up as a tough one for the stock market. Can’t be much more wrong that that! So far during September the Nasdaq 100 has been up 12 of 13 trading days. In the article I also lamented the fact that I hate being bearish because either, a) you are wrong and you look like a fool, or, b) you are right and a lot of people lose a lot of money. Well, not to worry. So far this month, the score is “A Lot of People: one; Jay: nothing.” Which I am OK with (fortunately for me I have some prior experience in looking foolish).
Still, the thing about the “stock market game” is that the game is never actually “over.” Play continues the next day, and the day after that and so on. So maybe things will turn around, maybe they won’t. As I write, some major stock indices appear to be breaking out above resistance while others have not yet done so. Likewise, a key moving average crossover pair has yet to cross over to the bullish side. By the time you read this all of this may have changed; but for now, consider the charts that appear in Figure 1.
Clockwise from upper left: the Dow Industrials, the S&P 500 ETF (ticker SPY), the Nasdaq 100 ETF (ticker QQQQ) and the Russell 2000 ETF (ticker IWM).
Figure 1 – Major indexes; some at resistance and 50-day moving average still below 200-day moving average for all
click here for larger view
Regarding these major stock market averages:
•The Nasdaq (QQQQ) has moved decisively above resistance, the S&P 500 and the Dow have “poked” above resistance and the Russell 2000 (IWM) is the laggard and has yet to move above recent resistance. As long as these averages hold above recent resistance things look good. If instead they “run out of steam” and drop back below these key levels, then not so much.
•For the moment, the 50-day moving average for each of these indexes is still below its respective 200-day moving average.
All of this could change quickly. All the indexes have to do is “keep going up” and “resistance levels” and “moving average crossover” concerns simply melt away. But until that happens, guessing what will happen next is simply speculation.
STEPS TO TAKE WHEN YOU ARE WRONG
Step 1. Have a Plan
Actually, this step should have been taken long before you were “wrong” in the first place. Everyone will be wrong about the market from time to time. That is one of those universal truths that no one likes to think about. The first “step” to surviving one’s “foolish” periods is to know that you have a solid, objective plan in place. My plan involves lightening up on stock market holdings under certain circumstances. The idea is to (hopefully) miss the bulk of any extended market declines. It also comes with the baggage of knowing that there will be “fake outs” and “whipsaws” – i.e., times when the indicators say “caution," but the market dip proves short-lived and/or relatively shallow. On those occasions one may have to swallow his or her pride, buy back in at a higher level and simply accept the fact that part of a move was missed. Such is the life of an objective investor. Which leads us to:
Jay’s Trading Maxim #2: Have a Plan, and also to Jay’s Trading Maxim #217: Have a Clue!
Step 2. Cut Losses as Needed
Personally I lightened up on stock market related investments in early August, so after August’s plunge and September’s rally I am only a few percent behind where I might have been if I had stayed in. The real danger comes if you take an “opposite” position. In other words, if for example I had sold short stocks or stock index futures I would now be sitting on an actual paper loss. Thus, the second step to surviving “being wrong” is to determine if and when you need to cut a loss and to then act decisively if and when that point is reached (this is where a stop-loss order comes in handy). This leads us to:
Jay’s Trading Maxim #4: Cut your losses, and to Jay’s Trading Maxim #312: It is OK to lose money from time to time, but it is NOT OK to lose a lot of money while shouting all the while, “but the market should be [insert you’re mistaken outlook here]!!!!”
Step 3. Get ready to bite the bullet and get back in (but wait for a true signal)
Once the market starts moving opposite of the direction you expected it to move there is a natural temptation to “do something,” even though your plan says to wait for the appropriate time. This is where psychology and discipline as an investor becomes a challenge. If you do not have a plan, or if you have a plan but you fail to follow it, the emotional baggage that results may stay with you for a long time and unduly influence subsequent investment decisions. The point is that if you don’t have a plan you never know how crazy you might get and if you do have a plan but you fail to follow it then you set yourself up for more doubt and second-guessing down the road.
Jay Trading Maxim #3: If you are going to develop an investment plan, you might as well make it a good one. And if you have a good trading plan, you might as well follow it.
So does all this mean that I have checked out of “Camp Bear” and am ready to join the suddenly growing crowd over at “Camp Bull”? Well, not just yet. The trend-following indicators that I follow are still mixed to bearish, the seasonal trends are still bearish and at this point the market is actually quite overbought on a short-term basis. So here I sit at “Camp Bear” trying as hard as I can to avoid making eye contact with anyone. Because the bears are getting very grumpy.
So the bottom line is this: the market has rallied very strongly of late but the jury is still out. Which sounds to me like a good time to consider “The Garbage Trade.”
THE GARBAGE TRADE
This strategy was taught at Optionetics OASIS 2010 by my fellow Optionetics Instructor Gustavo Guzman, and I wrote about it shortly thereafter. The basic idea is to “risk a little” and maybe “make a lot” essentially as a hedge against a market decline. The basic plan is this:
•Buy an out-of-the-money put option
•Sell two further out of the money put options to pay the first one
•Buy another further out of the money put option to form a butterfly spread
How’s that you say? Let’s consider an example. Figures 2 and 3 display a “garbage trade” using put options on QQQQ, an exchange-traded fund that tracks the Nasdaq 100. The trade highlighted is very short term in nature (less than a month to expiration) and should be viewed strictly as a speculative play (likewise no one should “bet the ranch”).
You should also note that this trade is slightly different than what Gustavo recommends. Typically you would want to buy a put option that is about 5% out-of-the-money and with more than 25 days left until expiration so that the market has some time to move. So I am taking liberties with his original method here. In this case I am looking at buying the short-term at-the-money put option (rather than going 5% out-of-the-money) in order to be in a position to profit if the Nasdaq pulls back even a little in the weeks ahead. Still in all, the purpose of this example is not so much to “give you a fish” but rather to “teach you to fish," i.e., to teach you how to enter a very low cost hedge “when in doubt.”
Figure 2 – QQQQ “Garbage Trade”
Figure 3 – Risk Curves for QQQQ “Garbage Trade”
As you can see in Figures 2 and 3, if QQQQ:
•Fails to drop below 48.20 by October expiration, this trade will likely experience a complete loss of the premium paid (hence the reason you should not put more than a small amount of capital into any “garbage trade”).
•Is between 41.80 and 48.20 at October expiration, this trade will make money. The closer the price of QQQQ is to 45, the more money the trade will make.
•Is between 42.70 and 47.30 at October expiration, this trade could generate a return of 100% or more.
So in a nutshell, if the rally continues, this trade amounts to an “insurance premium paid.” Conversely, if the market does turn back down in the next month, this trade can generate a decent profit.
I am a market expert (OK, at least that’s what I tell my friends). And as a market expert I must therefore know a lot about the financial markets. And if there is one thing I know for sure more than anything else it is that every investor will be wrong from time to time. As such, one of the keys to long-term success is to be prepared in advance to deal with those occasions without inflicting any more damage on your psyche or to your trading account.
I hope the steps that I’ve laid out in this article help you the next time you are wrong as much as they are helping me. Right now. While I am wrong. But hey, it’s my own fault for “hoping I’d be wrong.” Which leads to:
Jay’s Trading (and life in general) Maxim #752: Be careful what you wish for.
Staff Writer and Author of Seasonal Stock Market Trends
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