Thrill Ride Thursday: Finding Bottom

by: Philip Davis

Click to enlarge chart

MacDuff once said:

I grant him bloody,

Luxurious, avaricious, false, deceitful,
Sudden, malicious, smacking of every sin
That has a name; but there's no bottom, none.

That's the way the markets feel this week as we - like Henry V - head once more into the breach (or close the wall up with our EU dead). I had said on Tuesday that it was 1,200 or bust on the S&P (as usual) and we failed to hold 1,200 and we busted and then we failed to hold the bottom of the rising channel David Fry had drawn at the top of that post (117.5 on this chart) and so we tumble back down toward our much more reliable -5% line at 1,140, which I drew in red.

While tricky, it is not impossible to trade this kind of action. We are very fortunate to have been trading this exact range on our virtual $25,000 portfolio and we just had our best two weeks of the year, despite the insanity, with a net $16,475 gain since 9/15. That's 66% of $25,000 right there and we're now at $97,400 and on track to hit our $100K goal for the year on Friday as long as the Russell doesn't fail 645. If not, as with many trades this year - we'll work it out!

That's the whole point of this portfolio exercise - to illustrate the idea of balance, even in aggressive short-term trading. We are never all bullish or all bearish and sometimes we're wrong but, generally, we simply do more shorting at the top of our range and more buying at the bottom of our range and then we simply sit back and wait for the winners to come in. Of course for almost every winner there's a loser but then, a week later, the losers are winners too!

OK, so PATIENCE and BALANCE - those are our two points! And taking profits off the table. Right, then our THREE points are patience and balance and taking profits off the table while not being greedy. So that's FOUR points. Amongst our points are Patience and Balance, Taking Profits off the Table and Not Being Greedy.

As I often say to members, if you wake up in the morning and you're not sure if you want the markets to go up or go down - you are well balanced! Other than our long-standing gold short, which we'll be taking at least half off the table up 70% around $1,600 - we have practically no net cash in play as we've sold as much premium as we've purchased so we're not only playing both sides of the fence but we are following the main PSW strategy of BEING THE HOUSE - NOT THE GAMBLER. By constantly selling premium, we have a huge advantage - especially in a range-bound market (see also, Range-Trading 101).

The hardest thing about range trading is following Warren Buffett's advice to "Be greedy when others are fearful and be fearful when others are greedy." Yesterday we discussed the importance of ignoring the noise of the rumor mill and focusing on the FACTS as we make our investing decisions. With shorter-term TRADING, we have to pay a bit more attention to the technicals but it's all about taking small profits over and over again. In the $25KP, there were 35 positions closed out in 10 days of trading with nine of them losers and only seven trades went over $500 (20% of an allocation) in either direction. Like the Who song - we go in and out and in and out and in and out and like the Tom Petty song goes - "Even the losers, get lucky sometimes."

It's the losers that we're left with when we're range trading. At the moment, the RUT Friday $645 puts are killing us with a $4,250 loss - so we haven't close it! If it continues to be a loser on expiration day, we'll roll it out to the October $550 puts and, if the Russell drops 10% between now and October 21st, that will be fantastic for our loser hedges on EDZ and DXD. See - BALANCE!

That's how we make our adjustments every day. We began the day cautiously optimistic but the Dow failed our 10,300 line and gave us a re-entry on the DIA puts I mentioned in the morning post. In the morning alert we took a stab at a bullish TNA spread, which got cheaper as the day wore on (ie. another temporary loser), but it's the kind of trade where we risk $400 to make $5,000 and we can try those 10 times with 2 successes and end up doing quite well. For BALANCE I pointed out, in the same alert, that the USO Oct $32 puts should be a good play at $1.10 - they jumped to $2 at the day's end (up 80%).

As the markets became uncertain in the afternoon, we revisited our Long Put List and came up with eight stocks to short in case of a collapse but, when push came to shove at the end of the day - we remained 60-66% bullish (15/10 or 20/15 allocations), going long on AGQ into the close off the $105 line as well as grabbing an aggressive 20 IWM Friday $65/66 bull call spread for .65 ($1,300) in our $25KP, offsetting the purchase with the sale of 10 VLO Oct $18 puts at .86 ($860) for a net $440 on the $2,000 spread.

Peabody Energy (BTU) looked oversold as well and my comment to our members at 3:10 was:

Funny how people are freaking out on this pullback as the Dow was at 10,600 last Thursday and ran up almost 800 points (7.5% on the button) and is now 11,100, still up 500 points (4.7%) so, on the whole, a nice normal, 38% Fibonacci retrace of the 5-day run and all the talking heads are trying to pin reasons on it and everyone is trying to read the tea leaves and extrapolate the next week or month off what happened in the last 5 hours – MADNESS!!!

We had a terrible close but we kept the faith as we could see that the sell-off was based on more BS commentary led by the every-hawkish and finally leaving Bill Hoenig (don't let the door hit you in the rear, Bill!) as well as the other relentless negative news flow, which I have been warning all week was aimed at flushing TRADERS (not investors, who should know better) out of their positions ahead of the normal end-of quarter window dressing. If we don't get it - THEN we'll get more negative but we're going to give it the old college try through Friday - as long as the Dow can hold 11,000 and the RUT 650 anyway...

I spent last week laying the foundation for why we should not be freaking out about Greece, but one thing I have learned is you can't preach fundamentals to TA people (or use logic on conservatives) - the words just wash over them like the dog in this Farside cartoon.

Bernanke did not say anything in particular to deny Hoenig's allegations that the Fed is running a gigantic Ponzi scheme (they are) but, as I said yesterday (the same 3:10 comment to members): "I’d rather play the bull side until the bears prove their case because the absence of constant, relentless bad news is likely to cause a rally."

We went over the latest news at 1:20 this morning in member chat and, as expected, we were running out of bad news already after such a relentless attack at the beginning of the week. Goldman Sachs (NYSE:GS) spiked the futures down at 6 p.m. by releasing a well-timed comment lowering earnings expectations on U.S. banks. Taking the opposite side of GS calls like that is a very profitable business - a tactic they have been accused of taking against their own clients!

As we expected, GS was joined by the bond bears, who were desperate to get TLT back off the floor in a trade that is going horribly wrong for the Treasury bulls (not us, we were bearish). Will Greece default? Will China implode? What will be the next thing we worry about?

Germany approved the expansion of the ESFS 523 to 85 - not even a little bit close!

This is the exact opposite of what 99.9% of the "news" was saying and I even challenged members yesterday to find articles that said something positive about the EU and it was slim pickings for sure! Now the 140% expansion of the still-unused rescue fund to $600Bn will be questioned as "too small" even though Greece needs just $11Bn to pay for this year's needs and, of course, since there is still an EU parliamentary process to go through - we will still see the Punditocracy banging the fear drums as they chase the beautiful sheeple in and out of positions at will.

Our own Q2 GDP (in case anyone still cares about FACTS) came in up 1.3%, 30% HIGHER than the last estimate. Prices were up 3.3%, which is down from 4% in Q1, personal consumption was up 0.7% and exports were up 3.6% - ahead of imports up just 1.4% as oil calmed down. "Only" 391,000 people lost jobs last week, down about 10% from last week and continuing claims trended down as well. Our Corporate Masters made 3.1% more profits in Q2 this year than last year and that's up 210% from Q1's pace. Financial profits were a drag, down 11.5% but non-financial profits were up 8.4%.

While the obvious conclusion here is simply DON'T INVEST IN FINANCIALS - XLF is actually down 20% from last year's Q3 but after Q3 the earnings were good enough to pop the financials to $17 through Q2 this year so I suppose, if you think the financials will never make money again rather than that maybe, just maybe, it's a cyclical business and always has been - then you can not invest.

If, on the other hand, you think that people will still put money in banks and that not everyone will pay cash to buy homes and cars in the future with money they pull from their mattress and if you then believe (and this is the big stretch) that bankers will be able to make a profit from facillitating these transactions - then LOGICALLY, the XLF is a very good deal at $12.

The XLF 2013 $10/11 bull call spread is .45 and you can buy 50 of those for $2,250 and you can sell 20 2013 $9 puts for $1.10 ($2,200) and that puts you into $5,000 worth of of spreads for net $50 with a 100:1 return (10,000%) if XLF manages to hold $11 or higher through Jan 18th, 2013. Your worst case on this trade is the risk of being assigned 2,000 shares of XLF at net $9.05 - 25% below the current price. Obviously, if you don't REALLY want to be long on the financials at $9.05, then don't spend $50 on this trade - we're just being a little bit greedy while others are fearful...

Again, we are not gung-ho bullish but we're not giving up yet and taking on trades that pay off UNLESS XLF falls another 10% and don't lose more than $50 of our allocation UNLESS XLF falls another 25% is not exactly throwing caution to the wind, is it?

Not only that but, as demonstrated in our short-term trading - we KNOW we can make money on a move down so, as long as we stay "Cashy and Cautious" - it doesn't make sense to stay entirely on the sidelines.

We only fear missing a rally as we may never get another chance at these lows. While it's possible that we get that 25% decline, we don't fear that either as we will simply scale in and take net entries that are 40% lower than we are now and, if the markets fall that far and never recover - we'll be a lot more concerned about stocking the shelter up with ammo than we will be about whether or not our XLF trade is performing well.

Disclosure: I am long AGQ, FAS, IWM, XLF, USO.

Additional disclosure: Positions as indicated but subject to change.