Green Shoots Get a Reality Check

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 |  Includes: FIG, IWM, IYR, SPY, TLT
by: Vikram Saxena
After almost two months of bullish action, the equity markets finally got a reality check with the announcement of lower than expected retail sales data, and sharp rise in the number of home-owners facing foreclosure. The market gapped down at open, and did not make any attempt to fill the gap. All rally attempts were feeble and met with further selling. The markets closed near the low of the day, with the decline being led by the Russell 2000 small cap index, showing a decreasing risk appetite. Bonds got a bid and yields continue to decline across the curve.
Prudence Pays Off, Finally
Yesterday, I had written that though I had been waiting for a pullback to buy, I was too chicken to buy when the opportunity showed up with the S&P500 below the 900 level. Though at the back of my mind, I was afraid that the S&P500 will make a run towards its 200 day MA, my prudence in not chasing the rally paid off today.
S&P 500 Finds Support
Though the indices finished close to the lows of the day, the SPX found support in the low 880s and did not break that level in spite of multiple tests. The market internals were heavily bearish with both the market breadth and advance-decline lines at extremely negative levels throughout the day. However, the ES futures did not break below 880 in spite of being at a striking distance much of the afternoon, ignoring the horrible market internals.
To me the price action today showed two things:
(1) The Bears were delighted to make a profit today but were reluctant to press their luck too far. This also means that there is a greater risk of a vicious sell-off since short covering is unlikely to provide any meaningful buying support.
(2) The Bulls have not lost hope, and the buy on the dip mentality is still alive.
If the S&P500 can hold the 875-880 level tomorrow, we are likely to see another bullish run before this rally ends. However, I do not see anything which suggests that the new high price level will hold.
My Portfolio: Taking Profits on Puts
I used the drop today to book profits on my put positions in IYR and FIG. Though I was a bit early in selling calls on my TLT positions, the high volatility premium and the rapid time decay for options expiring this Friday still made them worthwhile.
Day-Trading Options
I also traded options today, primarily selling calls and puts, for intra-day trades. Though selling options left me with a negative gamma and limited upside, the rapid intra-day time decay helps cushion any position which moves against me. This was very useful during the afternoon where the market chopped around the lows of the day without making a big move either way. This strategy requires careful position management since your downside risk is not limited when you are short the option, unlike the long option position. However it allows you to make a profit even if the underlying moves against you to some extent.
The other strategy of course is to buy calls and puts, with the hope that the high gamma of options near expiration will help you profit from a big move. However, I did not see that strategy work today with the big gap down having done most of the work already. Though there were some trending periods, most of the afternoon was spent in range bound churning where the time-decay of long option positions would have hurt profits.
Trading Plan: Fade the Bounce, but Buy Precious Metals on Dips
I believe that this rally has run out of positive catalysts to make a sustainable move forward. I intend to open new bearish put positions on any significant bounce as we move into expiration Friday. The June Expiry cycle is long (5 weeks) and provides ample time for the underlying equity to make a move with limited time decay.
If we do break through the 875 level with conviction, I plan to add outright short positions. My focus would be on sectors which have made a run in the later part of this rally and have not yet corrected significantly. The sectors which led the early part of the rally, like Tech, financials and home builders have already corrected. The most appealing candidates seem to be in the energy, materials and the industrial space.

As a hedge, I may consider opening long positions in the precious metal sector, especially silver and the miners on any pullback. Precious metals are in a sweet spot now, since they not only benefit from the reflation trade inspired by the green-shoots, but will also do well in the flight to safety trade.