A Low-Risk Stock Trade

The equity market ended January with renewed selling squalls pressing stocks lower, reversing all gains from an early week rally, sending disheartened investors scurrying for cover. On Monday, the continued decline in stock account balances, the constant barrage of negative news from the media, and weakness of overseas markets set the stage for a nearly -2% gap lower, as investors began to lose faith stocks will ever move higher.

These were the facts early Monday morning. As a trader, though, one must observe the early market action and determine whether the pull-back would continue. So today, it might be helpful to spend some time discussing Monday’s action and how our tactics changed as the day progressed.

On the opening, S&P futures had gapped below Friday’s low of 817.50 (overnight low was 806.25) and were getting ominously close to breaching the 800 support level. New buying would be postponed until we observed the action of the first hour; specifically, would the market make a stand in the morning or would disillusioned traders throw in the towel and start hitting any bids prior to the “inevitable” test of 740-750, which were the November lows?

With the market down hard for two days going into the weekend and knifing through the prior day lows on the opening, a low-risk trade is to buy the market once it recaptures the previous days’ low, placing a stop at the day’s earlier low (I believe Larry Williams called this trade his “oops” trade). Thus, if the S&P future traded back above 817.5 (especially if this occurred during the first 2 hours of trade), we would look to go long, figuring a short-term washout was at hand. This happened around 10:20 am, so we began looking for stocks to purchase. We managed to sell some puts in FSLR, POT, BHP, WMT, WHR, BBY, and SNDK, while buying INTC and LLTC stock outright.

The market was choppy all day but respected certain levels were we watching; once the March S&P hit its morning high of 827 (just above the overnight high of 826.25), it pulled back and tested the 814 level — the area of a pre-opening high, which held for 6 hours prior to the New York opening. Once this level held, buying emerged into the bell as the S&P climbed to a marginal new daily high before easing a bit into the close.

This set-up has a very high success rate and can be used by traders to put on a directional day trade (just reverse the entry requirements for a short sale-two days of gains and gapping above the prior day’s high on the third day, put out a sale after trading below the prior day highs), and has a clearly defined tight stop, taking emotion out of the trade.

Yesterday then, good leadership came from high beta stocks -AAPL, RIMM, AMZN, GS- and from the semis (SMH+2.88%), which were bid up long before the broad market turned. Although the DJIA (^DJI) and S&P 500 (^GSPC) finished in the red, and the first few days of a month usually have a bullish bias, underneath the surface some constructive patterns emerged. Whether this action is constructive enough to launch a sustainable rally remains to be seen.

We have to believe there is some value in Wal-Mart (WMT), down -25% in a few short months to 46.57 from the low sixties. We understand that unions have renewed clout in the Obama administration, but we like our chances making money by beginning to ladder into out-of-the-money puts sales in WMT. We shall see.

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