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6,362 posts
msg #47905
Ignore TheRumpledOne
11/10/2006 3:41:08 PM

In today's email...

Friday, November 10, 2006

by Scott Kramer of

Now that the Dow Jones is, by some people's estimate, in the stratosphere, I am getting many questions about selling a top. Though there are some indicators that help map out when a market reversal is imminent, attempting to time a market can be costly and frustrating. Even if you feel that the markets are overbought and acting irrational, they can remain irrational longer than you can remain solvent, should you attempt to fight the trend.

Riding the Trend

How do you know if the market is in a trend? To be honest, I don't know of any other way other than missing a good chunk of the trend. Yes, there are technical, fundamental and other indicators that can help you make an educated guess as to when a trend is about to begin, but it is all assumptions. Until the market moves, you don't have a trend.

The hard thing to come to grips with as a new trader is allowing a good portion of the move to slide past you and feeling as if you are giving up potential profit every month you don't get in. But the bigger the trend as measured by past movement, the safer it is to ride such a trend. It is much like surfing. Yet, the longer the trend runs the more apprehensive most newbies are to catching the wave for fear of getting caught when it crashes.

As option traders we have less to fear and more to look forward to during such conditions. Think about it in current conditions utilizing vertical call spreads. Let me explain. Not too long ago, the market was literally parked between DJIA 10,000 and 10,500. For over a year 10,000 and 10,500 took turns being the swivel point by which the market gyrated around. Without saying "I told you so," the moment the Dow broke through 10,500 I made a statement that we would see Dow 12,000 before 10,000 as we had broken out of a consolidation range. In reality, I am the benefactor of luck more than insight or skill, but I will take the kudos nonetheless. God knows I don't get many compliments at home, so I will take an ego boosting where I can.

Suppose you wait until Dow 12,000 before being convinced that this time it is a bull trend. At 11,000 you thought the top was here. At 11,500, you thought the markets finally squeezed out all the short positions. At 12,000 you are convinced the end is here. Now, at 12,100 the market can't sell off and you are thinking to yourself, "Wow, I am missing a bull market". So what? I personally would rather be missing out on potential uncertain profits, than actualizing real losses.

You decide that it is now finally safe to jump into the market. You have no idea where the trend will end, but you decide that timing the market is working so it is time to do something different. Call it a new found Taoist attitude where you will be at harmony with your environment instead of fighting it. You really only need to be right the first month to potentially do well with options trading.

Let's say for example reasons that you elect to purchase a $5 wide ATM call vertical for $1.50 and you are correct to do so. The market runs up yet another month and your $1.50 investment becomes $3.50. You now can be wrong the next two months in a row doing the same trade and be up $0.50 before commissions. If the trend ends after your first winner, two subsequent months of losers will likely tell you the trend is over. If you manage to squeak out a second, third or tenth winner before the losing trade occurs, all the better.

How will you now when the end of the rally is near?

There will likely be a few clues when the end is near, some of which may be:

The cover of major magazines will spotlight articles selling the public on why the market is not overbought, but could actually keep rising. These articles will most likely have very believable and convincing arguments why P/E, PEG, and other ratios are not as high as they appear. They may also manipulate a variable such as interest rates or historical P/E ratios to make their stock valuations fit the argument.
The VIX (the Volatility Index) will be near record lows. The VIX measures the market's sum total of fear and greed. A high VIX indicates that people are very nervous about the markets potential to fall, whereas a low VIX indicates complacency and lack of concern. The truly amazing thing is that after an initial run up in the market people often get nervous about a potential for a sell-off; however, the longer the run up the more the concern dissipates and a total sense of "this time it is a real bull market" becomes general mood of the average market participant.
After a couple of major run-ups in the market after good news, which later in hindsight appear to be well overdone, a tight an jagged range may occur on high volume. This can be an indication of the "big boys" selling and taking profits and unloading it to the naive and greedy late comers to the party. At the end of the day you may actually think to yourself, "Wow...that was huge volume for a market that didn't really move anywhere today." This usually occurs a few days before the initial hard break in the market.
Any my favorite indicator....'The Dumbest Guy on the Block" (aka DGB) indicator. This is a certain sign of a top. When the least motivated and intellectually gifted individual in your neighborhood is making large purchases from his stock windfall, or bragging about how he just became a millionaire, you just have to know the easy money is near an end. Unfortunately, these are also the same people who are such gifted stock pickers and so intelligent that they have no use for options as a form of locking in and protecting their all too temporary profits. The only consolation to having to endure the mindless cacophony the DGB for weeks of gloating is that when they do give it back, and they always do, you wont have to see him again more a year. If you are a bigger person than I, you might want to turn them on to Optionetics so that there will not be a next time. Me? I prefer the quiet and muffled crying sounds of a grown man howling into a pillow at 300 yards.
Remember, when the market downturn happens, simply turn the position around like you made a wrong turn while driving. There is no prize for being the first one to sell the top. Yes, the early bird may get the worm, but the second mouse gets the cheese.

Scott Kramer
Staff Writer and Trading Strategist ~ Your Options Education Site
Visit Scott Kramer's Forum

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