We Got the Reversal. Buy Calls and Sell Out of the Money Put Credit Spreads.

June 25, 2013

Yesterday the market hit an air pocket and the S&P 500 was down 30 points. Stocks rallied sharply off of that low and I believe we have established a hard bottom. That low (SPY $156) should serve as support the rest of the summer.

China’s stock market fell 5% Sunday night and that was the catalyst behind yesterday’s decline. Overnight, China’s stock market rebounded 6% off of an intraday low and that also looks like a capitulation low. Stocks in Europe rallied off of the price action in Asia. The S&P 500 is up 11 points before the open.

From my perspective, the recent selloff simply confirms that resistance is strong at the all-time high. We won’t be challenging it until economic conditions improve. That will take months.

Europe continues to struggle, but the flash PMI’s last week were little better than expected. Any improvement would go a long way. China’s economy has been slipping, but they are still growing at a rate of 7.7%. The PBOC said that they will not stimulate. Last night, they softened their tone and said that they will guide interest rates to a target. The market liked the change in tone. The Fed likes the fact that our economy has been able to shoulder the sequester. They see that as a positive sign and that is why they plan to taper.

The market fell below the 100-day moving average and it flushed out weak hands. The drop attracted bears and they are about to get squeezed. Conditions are not dire, they are stable. The SPY was below the 20-day Bollinger Band (two standard deviations) and we are technically due for a nice bounce.

Asset Managers have seen the support and they will bid more aggressively. Even if economic conditions muddle along, the market will be able to rally 5% and tread water. Central banks are accommodative, interest rates are near historic lows and stocks are trading at a reasonable P/E. Corporate balance sheets are stronger than ever and companies are using cash to buy back shares.

The news front is pretty quiet this week. Durable goods orders came in better-than-expected and we will get GDP tomorrow. The big releases (ISM manufacturing/services, ADP, official PMI’s and the Unemployment Report) will be released next week. In a holiday abbreviated week, the action could be fast.

I believe the economic releases will be better than feared and the market will rally back into the middle of the range SPY $157 – $168. We will chop back and forth within that range this summer. If economic activity improves, we will challenge the all-time high this fall. If not, September and October could get nasty.

I bought calls Friday (small size) and I added yesterday when we got that reversal off of the deep low. I added yesterday afternoon and I have a nice position on. If we trade above the 100-day moving average today I will add.

This is the game plan I outlined in my market comments yesterday. I also mentioned selling out of the money put credit spreads. Option premiums are higher than we’ve seen them in 2013 and this strategy is viable. The bounce this morning will drain option implied volatilities.

If you want to be more passive, sell out of the money put credit spreads on strong stocks. Distance yourself from the action and make sure that there is technical support above the strike price that you sell. If that support is breached, buy back the put credit spread.

I am looking for a nice rebound this morning and follow-through the rest of the week. The market is deeply oversold and the price action next week should be constructive as well.

It is important to note that I am not bullish. I simply feel that we need to trade the range. Don’t expect sustained moves. If we string two or three good days together, we are lucky. Set targets and take profits.

We will be using a hit-and-run strategy this summer.
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