Before The Open - Possible Bounce Today But Just A Bounce

I am writing this before the market opens. Actually I am writing this at 12:20 AM. The selloff today took off in the afternoon and with much of it being computer stock selling , it built upon itself. As more computers sold more stocks, eventually most of the S&P 500 and NASDAQ was being sold which then lead to even more selling. A billion shares were traded today and usually 70% are computers trading stocks..

This evening I read a lot of analysts who feel this is a great opportunity to purchase stocks for the next run up. They see nothing wrong with this pullback. In fact many see this as just a sideways consolidation action. They could be right or they could be wrong. While technically my charts look poor, they could easily be right and the markety march higher. While I may not have a clue as to the market direction from here I do know how to profit from either direction.

On Wednesday, I sold my SPY Puts around 3:30 PM as I thought there might be a bounce into the close, but that was not the case. I sold though because I want to build up my cash cushion to cover those times when I will buy puts and be wrong.Looking at today's action on the S&P 500 you can see that around the time I sold my SPY Puts, the market did bounce a little and then closed near the lows of the day, but NOT lower.

The key to tomorrow though may lie in the MACD. From 3:30 to the close MACD was flat and the Divergence was 0.00 - indicating no more selling.

It's important to remember that much of the day to day trading that occurs now on the S&P 500 is done by computers. For just pennies, these computers will trade up and down and sideways, generating millions of dollars in profits. The algorithms used are top secret but as a small investor I can take advantage of this by knowing that on big down days MACD can indicate to me what the computers are doing.

At the close for half an hour, on the S&P these computers were no longer selling. That probably means tomorrow will see buying as these same computers buy up many of the stocks they dumped today.

S&P 500 SPY HEDGE STRATEGY REVISITED

This is why I developed my hedging strategy years ago when the computers were just getting started. At that time they accounted for less than 25% of the stock trades. Today they account for 70% of all trades on the S&P 500. It is very important for me to NOT hold onto my SPY puts for very long. A few days is usually the longest, but a day or two is the normal holding period.

Computer trading while feared by many, actually helps to keep volatility up. Long before the VIX Volatility Index was developed, I used to manually calculate the market's volatility. It took quite a bit of work. Often in the 1980's the volatility would be 12.00 or even 10.00. But as computers have taken on more and more of the daily trading, the volatility index has a hard time falling much below 12.00.

Look at the 10 year VIX chart below. Look how RARELY the VIX got below $12.00, but how often it was above $15.00. This was often do to computer trading which can often push volatility higher as they "day trade" often for mere pennies.

This chart is of the VIX since 1991. Look how often from 1991 until 1996 the VIX was below $15.00. Computer trading did not make up 70% of daily trades in the 1990's.

Volatility, while difficult for investors to become accustomed to, actually benefits those of us who sell options. Today is a good example. On July 25 I sold Pepsi October $60 puts which brought in .82 cents. The stock was at $64.30 when I sold the puts. Today when the stock was at $64.40 those same puts were trading for .90 cents. Volatility had pushed up the premiums.

When the market pulls back in a big way, it marks an enormous opportunity for me to sell puts. When the market bounces I often have a chance to purchase those puts back and get ready to sell them again.

The same is the case with my SPY Puts which I have bought as a hedge. It is important to understand the strategy being employed. I am building up cash. But I know that when the market is falling as it was at 3:30 PM and the VIX was rising dramatically put premiums are OVER VALUED. The market maker is selling puts for above average premiums to take advantage of the rising volatility, but also to cover themselves in the event that the market is going to move lower. Market makers rarely lose money.

Therefore by keeping the VIX chart open I can easily tell when the volatility is climbing and compare it to the S&P 500. At 3:30 PM it was falling hard and the premiums for my SPY options climbed. I sold at $4.98 but within milliseconds there were higher traders than mine yet the index was pulling back up and the VIX was falling back slightly. Nonetheless the demand for the SPY puts pushed prices higher.  

By selling my SPY puts when I did I received a great premium for a very short period of 2 days. The profit is immediately locked in and I know from being in the market for many years now, that computer trading accounts for 70% of any action. Therefore this evening when I reviewed my charts MACD showed FLAT. That tells me that tomorrow there could be buying and that buying could result in these same computers jumping back in and buying and selling as they push stocks back up. It's a game, that's true, but by being aware of what is happening around me in the market, I can take advantage of the volatility these computers are creating and sell options for what is often over valued premiums.

SUMMARY

I hope this article is of value and interest in showing other investors how to take advantage of the marketplace we are now in. Remember though that any bounce is probably just that, a bounce as presently the trend remains probably lower. For positions where I have covered calls, on a day like today with the market falling, I buy them back. Tomorrow if there is a decent bounce, I would sell them again and sometimes I move down to the next lower strike because I have confidence that the market will turn down lower over the short term and many of my covered calls will end up out of the money. Remember there is not fast rule that says you must hold your option positions until the expiry. Often the better strategy is to play the volatility swings. For those investors who find days like today difficult, they should consider that cash is strategy that is very under rated especially when computer stock trading is bound to only increase with each passing year.