In today’s option trading blog is will address the current decline. The market has dropped 5% in less than 10 trading days from a multi-year high. A correction is defined as a move of at least 10% but not more than 20%. This move is classified as a sharp sell off at this point.
Before I can figure out if the move is over I have to identify the reason for the drop. If it is the result of a global political or economic event that will materially impact earnings long-term, the drop could be prolonged and I stand clear. 9/11 is a good example even though it had a very tradable bounce. In this case, higher interest rates and inflation have resulted from full employment and economic growth. Corporate earnings have been robust and balance sheets are strong. On the surface it seems to be a normal sell off. Caution: statements like this are dangerous because you start convincing yourself that a bounce is near. Let the market take its course.
As the market drops, I look for logical support areas. Prices will tend to find support at major moving averages (100, 200), trend lines and horizontal support levels. As the market moves through these points, I watch to see if any buying materializes. Eventually, the market will exhaust everyone and force them to throw in the towel. That move is often referred to as capitulation. In one last big move the market is likely to make a lower low than anyone expected. As long as everyone is expecting a bounce, the lows are not in. The very last speculator needs to be shaken out. I have not seen the level of panic or the aggressive buying that tells me the lows are in.
I’m looking for one nasty day where it looks like the world is falling apart and there are air pockets as the market moves lower. The low of the day will be tested and a violent bounce will occur. That bounce might rally the market back to unchanged for the day(intraday reversal). If the buying continues the next day and the market grinds higher (very few head fakes), I’ll feel confident the lows are in for the time being.
In this particular case, the SPY tested 126 (200-Day MA) and bounced. The market gapped up and failed creating an intraday reversal to the downside. This does not bode well for the open. The next level of support to be tested is 125. That level represented resistance last year and it now represents support. If that level is breached, 123 represents a long-term uptrend that began in 2004. If that level is breached 122 represents horizontal support.