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May, 2009 | Inthon - Part 3

The Nasdaq keeps rallying and hurting a trade which I put on last week (same time as I put on the Darden trade).  I bought two June 2009 31 Puts on the QQQQ’s (Nasdaq index) at 0.86 ($86 dollars each).

Rationale: My rationale for this trade was very ill-conceived and emotional.  I literally could not believe the market was rallying so strongly and felt I had to “Get A Piece Of The Action”.  While I do not have to call a top perfectly with an option trade to be profitable, it is still foolish to trade emotionally or based on gut-instinct.  I bought these options thinking the market would sharply turn down, so I bought June options which will be due on June 29th.  Like a fool, I failed to study the chart and I was disconcerted by what I found once I looked at it.

Here is the chart of the QQQQ’s:

qqqq

There are two things that jump out at me:

  1. There is an obvious double-bottom which is a very bullish indicator.  It is nearly a textbook double-bottom, which, despite the fundamentals of the Nasdaq, makes a compelling case for putting in a short-term bottom.
  2. A common trading rule of thumb is that tech stocks lead the rally.  Meaning, the Nasdaq would be the first place any sign of strength would first appear.  As such, if the other indicies (S&P, Dow) aren’t confirming a bottom, this isn’t necessary since the Nasdaq would be the first place strength would appear.

Below is a chart of the Dow, which displays a weak, V-shaped bottom, which is clearly far weaker than the Nasdaq (shown above).

_dji

Comfort Level

I am not very comfortable with this trade, especially since the market has done so well despite news of Swine Flu and the bankruptcy of Chrysler.  To feel at ease with your trades, there are certain rules you must obey.  Feeling like you need to “Get A Piece Of The Action” is probably the stupidest way to trade I can think of.  I have done this numerous times after seeing, reading, or hearing something provocative.  Just like you cannot let an errant comment from a co-worker provoke you or cause you to react erratically, you must also exercise this self-discipline and control when trading.

Feeling like you need to “Get A Piece Of The Action” is the triumph of emotion over reason.  With reverse ETFs, option strategies and leveraged ETFs, there are ways to profit in up, down and sideways markets and you should never have a need to jump in without carefully weighing the pros and cons of a trade.  It is better to paper-trade and learn, rather than risk losing hard-earned cash, especially if you don’t have a huge account (like me).

Again, there will ALWAYS be opportunities to make money in up, down and sideways markets.  Never get into a trade just because you feel you are missing out or you want to feel like you have something at stake in the market.

Compared to the Darden trade, the Darden trade looks much better given that it is not a market leader, has more time to show weakness, and has rallied even more sharply/irrationally.

Exit

My strategy with this will be to set a trailing stop if and when the value of the options double.  A trailing stop will allow me to exit the position if the price drops below my stop price, but if the market keeps moving in my favor, it will raise my stop, allowing me lock in even more of the gains.  I have never used trailing stops, but hopefully I will get a chance to use them and learn with this trade.  Since the total cost of these options were less than $200, I am comfortable holding them until expiration and seeing them expire worthless, if the Nasdaq does not decline strongly.

Takeaway

I try to resist GAPOTA trades, but I sometimes succumb to the temptation to risk a little bit of cash when I see such a parabolic rally.  Hopefully, the Nasdaq will turn around and I will get to exit gracefully, however, I’ll learn from this trade either way.

DISCLAIMER:  All opinions expressed on this website are solely my own and do not reflect the opinions of anyone else. You should not treat any opinion expressed on this website as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinion. My opinions are based upon information I consider reliable, but I do not verify its completeness or accuracy, and it should not be relied upon as such. I am not under any obligation to update or correct any information provided on this website. My statements and opinions are subject to change without notice.  Past performance is not indicative of future results.  Risk of loss exists in futures, options, equities trading.

The stock market is still rallying strongly and my hopes for a drop last week to benefit my Darden trade went unfulfilled.  Nevertheless, the beauty of buying an option, like I did with the Darden trade and the Nasdaq trade (which will be posted later this week), is that you are paying a “time premium” for the option, which gives you the luxury of not having to time the bottom perfectly or be exposed to a potential margin call from a market move which does not go your way.  I feel confident holding the trade even though the market has rallied since I do not think this latest rally is indicative of a true bottom.

The market has shaken off bad news about two historic events:  the bankruptcy of Chrysler and the Swine Flu.

Incredibly, the market seems to be chugging right along and unfazed by these developments.  Being a fan of technical analysis (charting), I went back to the charts to look at the powerful recovery of March 2003.  Right after the US invaded Iraq, the market began to soar.  I went back to look at the chart to see if I could learn anything about that powerful, sustained rally.

Below is a chart of the rally:

djia-march-2003

As you can see, the rally in March of 2003 had two prior bottoms that were put in, both of which were nearly lower. 

As a result, this level on the Dow provided a solid level of support (buyers), that stood at the ready to buoy (via buying) the market.

The same cannot be said of the March 2009 low.  The bottom has not yet been re-tested and no solid base of support has been established.  As a result, I think the March 2009 lows need to be re-tested until we can declare that the bear is dead and this rally is for real.

The March 2003 rally was preceded by trampoline-like bounces of +11%, -15%, +18%, -13% before the sustained rally of 30% that closed out 2003.  I do not believe that the market can have a durable rally with a V-shaped bottom without putting in a rounded bottom or multiple touches of a bottom.  I suspect we might see similar 2003-like bounces up and down before any sustained rally will take place.

Takeaways:

  1. The market hates uncertainty.  The post 9/11 malaise and sabre-rattling around Iraq proved to be distracting and the market from post 9/11 to March 2003 was a wreck.  Once the invasion and “quick victory” were established, there was more confidence in the market.
  2. A base or bottom needs to be established with considerable support, which has been tested more than once.
  3. In a “false bottom” such as this one, I feel comforted holding Puts against a consumer non-essential.

Note:  I apologize for the lack of clarity in the charts, better charts are on the way.

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