Nasdaq Still Leads Despite Sharp Drop

While the Nasdaq has fallen rather sharply lately, its still stronger than the NYSE composite based on 10-week relative strength. As I’ve discussed in the past, Nasdaq relative strength over the NYSE has generally been a positive for the market. I figured I’d look at this in the context of the recent selloff as well.



Glaring about this study is the low number of trades. This speaks to the relatively unusual market environment. While the 5 instances were somewhat mixed over the short-term, performance once you got out 13 weeks was strongly positive. For those interested, the trigger dates were 12/6/74, 8/8/75, 8/14/98, 8/6/99, and 7/19/02. ’74 and ’02 basically marked the bottoms. The other instances did some wiggling around before moving smartly higher.

To try and include some more instances, I loosened the “% drop” requirement for the Nasdaq. Lowering it to 5% produced the following results:



Not nearly as positive at the steeper 9% decline, but still very good on a risk/reward basis when looking out 10-20 weeks.

Nothing here that appears to be immediately actionable on its own, but as long as the Nasdaq can hold on to its leadership spot, the market stands a pretty good chance of putting in some intermediate-term gains.

Does A Lackadaisical Put/Call Keep The Market From Bouncing?

One measure of sentiment that is notably underwhelming is the CBOE Put/Call ratio. This is a concern for some traders. As of today the 10-day put/call was 101.3. This is actually lower than the 200-day moving average of 101.7. Below are two studies that show what has happened when negative price action has been accompanied by a lackadaisical put/call:



This first one I looked at both above and below the 200-day moving average, and it made little difference. The implication of the Put/Call tests seems to be that a relatively low Put/Call doesn’t hurt the chance of a nice bounce. This was a bit surprising. Also a bit encouraging.

Using Options For Short-Term Trading - Part 2

Last week I discussed why and how I sometimes use options for short-term trades. Today I will expand on that with some rules I follow and other thoughts. If you didn’t catch last week’s post, you may want to check that out first.

As a very quick review, when trading in stocks or ETF’s that I anticipate being in for a number of days, rather than weeks or months, I frequently trade deep in the money options rather than the stock or ETF. The reasons and a general methodology were outlined last week. Below are some more specifics for you to consider along with answers to a few questions I received:

How do I decide whether an option is preferable to the stock?
Some general rules as to when I use options:
1) The stock should trade for at least $25 or more. The higher the better. I especially like stocks in the $40-$80 range. – The spread on many deep options is $0.10. Sometimes you’ll find something appropriate with a $0.05 spread, but not always. In many cases you can assume you will lose at least most of the spread on the trade. If I’m looking for a 2-3% move I don’t want to give away $0.10-$0.15 on a $15 stock. Doing that may destroy my edge. With low priced stocks I normally just buy the stock.
2) The option should have almost no premium – Even with higher priced stocks, I don’t want to pay much premium on the option. More than $0.15 or $0.20 and I begin to lose some interest. In low-volatility environments this is easily accomplished. During panic situations when the VIX spikes you’ll be hard pressed to find anything trading without a decent amount of premium.
3) I want enough time for the trade to work, but not too much time left on the option – The contracts are generally monthly. My trades average about 1 week. Two weeks to expiration is the sweet spot. Less than one week and I’m normally looking out to the next month (which means additional premium). Three weeks or longer and your going to have to pay for some time value. If the trade works quickly then you may be able to sell the option with time value left in it. There will be some erosion, though.
4) The delta should be 90 or higher – This is normally the case if you’re not paying much premium for a deep option. Basically, I want the price to move up very close to the same amount as the stock price.

What if the exit trigger doesn’t arrive before the option expires?
In this case some decisions need to be made. If I’m trading a stock then I’m normally not trading a size larger than I would trade if I owned the stock anyway. Therefore, taking delivery of the stock is an option. If it is index shares that I’m leveraged with, then I need to roll them out to the next month.

Rolling out to the next month adds some cost. First, you have basic transaction costs since you are selling your options and buying others. Frequently more significant is the premium cost. You are selling an option with 0 premium and buying one with some premium. To help reduce the amount of premium the roll will cost you, a spread trade normally helps. Rather than entering a sell for X contracts and then a buy for X contracts, put it in as a spread trade. Even though the option may trade with a $0.10 spread, you can enter spread trades to the penny.

When else might it be appropriate to switch option contracts?
If the trade goes sharply against you and you still feel positive about the position you could consider moving to a lower strike price (assuming long call). Two things will happen when your stock price rapidly approaches your strike price. 1) Premium may get built into the option since you are now near or at the money rather than deep into it. 2) The increase in premium will also mean a decrease in delta. So when the stock does bounce your option initially may go up $0.75 for every dollar rather than the $0.95 for every dollar that it would have when you bought it.

Therefore, one strategy to consider would be to sell the now “near the money” option you hold and buy a deep one. This accomplishes two things: 1) You are able to make money on the premium that was just built up and 2) You own an option with a higher delta that will rise faster than your original option.

Of course there is a big disadvantage to doing this, and that is that you are now laying out more capital. Part of the reason for using options is to control risk. Swapping out for deeper ones when the trade goes against you increases your initial risk, so it’s something that needs to be carefully thought through before doing it.

For index trades, why use options instead of futures?
There are advantages and disadvantages to both. Some advantages for options include: 1) They can be traded in the same account as stocks. No need to segregate to a futures account. 2) In low volatility environments, you can actually get more leveraged than with futures.

A big disadvantage rears its head in high volatility environments. When the market sells off hard and volatility spikes, even fairly deep index options carry a decent amount of premium. With futures this is not as much of an issue.

To sum up below are a list of advantages and disadvantages to using deep options for short-term trading vehicles:

Advantages:
Lower capital outlay
Lower risk (option goes to $0 before stock does)
Leverage without paying margin costs
Can be traded in same account as equities rather than separate futures account

Disadvantages:
Lower reward due to delta < 1
Higher slippage due to option spreads
Some premium costs
Premiums increase in volatile environments

A Breadth Indicator That's Suggesting A Bounce

In Gerald Appel’s book, “Technical Analysis – Power Tools For Active Investors” he discussed a breadth measure he uses to anticipate market rallies. Bascially, he takes a 10-day Exponential Moving Average of the NYSE advancing issues divided by the advancers + the decliners. In the book he discusses a system where a strong thrust upwards in this indicator frequently leads to rallies. I have found that strong downward moves also tend to lead to rallies.

According to my data provider, the 10-day Advancer EMA came in at 0.3714 on Tuesday. Below I looked at results for the S&P 500 following any time it dropped below 0.375:

These results are quite good, especially considering the averages had to absorb the max loss that occurred thanks to the Crash of ’87. You’ll notice I ran the test back to 1982. The reason being that prior to 1982 the system would have been a disaster. Look at the returns in the 70’s-1981:

While the indicator has not always worked, it has done a nice job over the last 25 years or so. It could also be used as a system parameter for a trade exit. Below I show the results of entering an index position when the indicator drops below 0.375 and then selling when it moves back above a certain number. Results here are from the 1982 – present period and are quite robust.

Selling Quiets During Narrow Range Day

I’ve discussed the pattern of a WR7 down followed by an NR7 in the past. Generally it’s had bullish implications over the short-term. When applied to a chart of the S&P 500 rather than SPY or the Nasdaq, the formations look a little different. This is because the S&P 500 has a staggered opening. Therefore the chart is basically gapless. These bars therefore more often look at true range rather than a bar with a large gap. Applying the WR7down – NR7 study to the S&P 500 chart yields the following results:


As in the Nasdaq study, WR7 down – NR7 implications appear bullish.

Another way to look at the last two days would be to ignore the size of the bar on Friday, and rather focus on the high level of volume. This next study does that:



Both studies seem to suggest the same thing. When a substantial selloff (measured in either price or volume) rapidly loses steam, the result is typically a bounce back up.

Also notable is the fact that the CBI hit “8” today. To see recently reported results following moves to 7 or higher, see the June 11th blog.

On the negative side, the VIX didn’t budge, the Put/Call ratio dropped precipitously, and it looks like another possible case of Draggin’ Breadth today.

Lastly, while the studies help to construct a market bias, the biggest mover in the next few days may be the Fed. Right now, that seems to be a wild card that could spark a move in either direction.

Selloff Doesn't Scare VIX

One gauge sometimes used to measure fear is the VIX. While the S&P 500 dropped sharply on Friday and closed below its lower Bollinger Band, the VIX barely nudged higher, closing less than 5% above its 10-day moving average. Below I examine other times this has happened:



Negative results on a fairly low number of trades. Interesting was the fact that most of the winners occurred in the early ‘90’s. The table below shows the results of the above test from 1993 – present.



The number of trades here is quite low, so it’s dangerous to read too much into it, but the implication appears to be negative. While the market is oversold, the Capitulative Breadth Indicator is back to 5, and a sharp bounce could ensue at any time, we may need to see a little more fear before it happens.

A Lame Reversal

In one of my first blog entries I looked at S&P 500 reversal bars that made new 20-day lows and then rallied strongly to finish the day up 1% or more on higher volume. A key ingredient in that study was the 1% price rise. While the market put in a reversal Thursday on increased volume the price rise was not that impressive. The first table below is the one from January’s study:


This next table shows what happens to reversal bars with unimpressive price advances like Thursday (again 1978-present):


The January study showed a clear edge to the upside from an average trade standpoint. That edge disappears when the reversal is weak. Doesn’t look like Thursday’s action is anything to get to hyped about.