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Sideways Market?

January 28, 2007
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The market has shown amazing resilience in recent months. But it continues to show chinks in its armor. Most notably this week, the SPX had a nice breakout day demolished by a bearish engulfing day to follow it. That leaves the index kissing the MA and heading toward a likely third red arrow. If it does break the MA, it will also likely break the support line from the channel since November. Nevertheless, the tracks for a downtrend will not begin to be laid until the last significant low at support in the 1410 area is broken. Until that time, we have to assume we’re still moving at least sideways, if not up.

The Nasdaq already has older red arrows on the MACD and Stochastic and a relatively fresh red arrow on the MA. Its breakout failed two weeks ago already, but what’s most amazing is that the big bearish engulfing on Thursday of this week happened right at the old resistance line. It’s just weird the way this stuff works out sometimes. In any case, sideways action seems even more likely on the Nasdaq, even if this 70 pt. wide channel is likely to be broken in the near future. The biggest message is that the uptrend is very much in question for the near future.

So this brings me to one of the basic principles taught by Investools. We should adapt our trading to the market. Though it may take time to become proficient and confident in such a variety of strategies, eventually we want to be able to make money in all markets, up, down or sideways. Here is the general application of strategies:

  • Uptrending market- Long stocks(buying), long call options
  • Sideways market – Covered calls, advanced options strategies(spreads, protective puts, etc.)
  • Downtrending market – Short stocks(selling), long put options

Of course, advanced options strategies can be applied to all markets, but this is the simple ideal. Theoretically, the best way to take the most money out of the market if you know what you’re doing.

With the assumption that we’re moving sideways, let’s explore what we might do if we were long shares of SPY. Assuming we’re using the Investools method, the 3 red arrows are a sell signal. However, for the purpose of not getting whipsawed in an intermediate term trade every time we show 3 red arrows, we might use the “3 and 3 rule.” This guides us to move our stop loss order up when we receive 3 red arrows to 3% below recent support or the MA. Using the MA currently at 142, that would put our stop at 137.74. (To find the level of 3% below support, just multiply the support level by .97)
Realize that because the SPY trades at 1/10 the size of the SPX this distance of over 4 points here is over 40 SPX points, seemingly quite a swing. If we’re in a longer term position, that would be a fairly normal occurrence to ride out. But who likes to ride out a 40 point down swing? Perhaps the seller of covered calls wouldn’t mind.

With the market showing signs of a sideways inclination but not yet a full blown down turn, three red arrows would be a good time to think about selling calls on our spy position.
Looking at resistance from the failed breakout being at 144, I would probably be most inclined to sell that strike price in case there is something of a bounce off the MA. This way, I’d still have some room to profit from the rise in the underlying shares owned.

Looking at the options chain as it is over the weekend(but will change somewhat at market open on Monday) we can get .60 for the Feb 144 call with 19 calendar days (15 trading days) left in its contract. With a credit of .60 taken in from the covered call, if we get called out upon the stock closing above 144 at expiration, our selling price will be essentially 144.60. One could also opt to sell the 143 for a higher credit, but the likelihood of being called out of the stock would be higher as you can tell from the Probability of Expiring (in the money) column.

One might even decide to sell the further out month to bring in more premium. Under 20 days out seems to be the recommended cut off for selling options, but 19 or 18 is probably okay if all the analysis is there. This is just getting into the rapid acceleration of time decay. Notice that the Theta is higher on the February options than on the March options. Ideally, as the stock moves sideways, we’ll burn down most of the time value on the Feb call and then roll it(buy back the Feb call for cheap and sell the March call at the same strike price).

While the downside of doing covered calls is capping your potential profits, sometimes it is still quite attractive to squeeze out a little more juice from a holding. Though it is certainly possible that the SPX would rally more than 24 pts. to beyond 14,460 in the next 3 weeks, judging from the analysis above, it seems unlikely. So in this case, though we’d be very happy to see the stock move above 144 and call us out for this profit, the strategy is being employed to “generate income” on our holding as some people say, or better yet, reduce our cost basis on the shares owned.

Another interesting strategy taught by the people at Thinkorswim would be to do a virtual covered call on your entire retirement account, assuming it’s in broad market funds. If you’re in Mutual funds that roughly track the SPX, you could sell calls of SPY just like we did here. But since you don’t own shares of SPY, they would be considered naked and you’d have unlimited risk since the index could shoot up to the moon. To cover the risk and keep it at a nice defined risk level, you would buy calls further out of the money than the ones you sold. You would then have the right to buy the stock just higher than where you’d obliged yourself to sell them to someone else. You could think about the bought calls as insurance. But being further OTM, they’ll cost less than the ones you’re selling. This creates a credit spread, in this case a Bear Call spread.
Using the quotes right now, it looks like a SPY Feb 144/145 call spread could bring in a credit of .30 or so, assuming we can fill somewhere between the bid and the mid price. Even if the market rallied hard and we lost the full .70 at risk in that spread, if the position were sized proportionally appropriate to your fund holdings, the profit in your funds would still compensate for the loss of this smaller position. Seems like a win/win situation. One could also do a bear call spread on the SPY even without mutual fund holdings, but you’re then risking betting against an essentially bullish market without the benefit of an underlying component picking up profits if the market rallies.

Of course, selling calls or credit spreads does not negate the damage done when the market turns south. When the blatant sell signals are given to get out of the market, simply buy back any short calls or call spreads.
Then, sell the underlying stock.

In closing, though I used the SPY as the model for selling covered calls on warning signs of an uptrend in trouble, this can of course be applied to stock holdings as they waver before either breaking down or resuming their uptrend.

On another subject, as if the whole risk factor hasn’t been beaten to death lately by yours truly, here’s an article from IBD on cutting losses short. Jeff Kohler has also recently done a blog posting about Position Sizing. Like mine, his postings are sometimes a bit on the casual side and less than definitive, but he gives good insights that are worth reading.

I will try in the next few posts to look at some of our stocks with an eye toward strategies for a sideways market.

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