(http://ca.finance.yahoo.com/echarts?s=^VIX#symbol=^vix;range=6m;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=;
Simon Maierhofer, On Friday December 10, 2010, 6:51 pm EST
It's said that an ounce of prevention is worth more than a pound of cure.
Fortunately for investors today, prevention seems to be overrated as the Fed is pumping liquidity into the markets.
The Fed feels indifferent that QE2, which is not much more than an asset purchase program, rewards the very banks (NYSEArca: KBE - News) and financial institutions (NYSEArca: XLF - News) that profited immensely from creating the 2007 bubble.
Ironically, the money being spent on 'preventing' a continuation of the economic meltdown is inflating another bubble. Today's easy money is coming from a different spigot, but it'll have the same effect - another bubble.
Stairs Up - Elevator Down
All is well as long as prices go up, but that can reverse suddenly. A commenter on ETFguide.com's message board used the analogy that the market is climbing up the stairs but taking the elevator down.
The chart below shows the long-term performance of the S&P 500 (SNP: ^GSPC) since the 2000 tech (NYSEArca: XLK - News) crash in one month candles. Note how the bear market moves much faster than a bull market.
In this article we'll discuss 1) How to make money on the upside without being vulnerable to another steep sell off and 2) What the chances are of a sharp correction visiting Wall Street.
Be Alert
Don't buy and then stick your head in the sand. Read between the lines and evaluate the investment environment. There are indicators that tell you when a market is overheating. This doesn't mean stocks will drop like a rock, but it's a good warning signal.
For example, on April 16, 2010, the ETF Profit Strategy Newsletter noted an extremely low put/call ratio and predicted a sharp decline. The put/call ratio indicated that investors/traders were so confident in rising prices that only one out of three bought put protection.
Puts serve as a safety net. Without a safety net, the bottom can drop out of the market. The 'Flash Crash' painfully highlighted the results of sentiment extremes combined with anemic put protection.
A similar setup occurred in December 2008 when the ETF Profit Strategy Newsletter predicted that optimism above Dow 9,000 will lead to a new low below Dow 7,400. Within the next 2 months, the Dow (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) lost between 24% and 29%.
Sentiment measures are a valuable indicator. However, it appears that QE2 has skewed the effectiveness of sentiment indicators. With much of QE2 money going straight into stocks (NYSEArca: VTI - News) and commodities (NYSEArca: DBA - News), sentiment readings will likely reach historic extremes before another significant top is reached.
Many Options
There are various ways to protect your long positions. The most straight-forward way is to buy put options. A put option gives you the right to sell a stock or ETF at a predetermined price (the strike price) regardless of what happens to the stock.
If you owned 100 shares of SPY at $123 ($12,300), a March strike price of $123 would cost you around $500. A $500 'insurance premium' would allow you to sell SPY at $123 on or before March 18, 2011, regardless of where SPY will trade in the future.
Instead of buying a put to protect your position, you can also sell a call to generate income and/or offset losses. You can sell the right to buy your SPY at $123 at any given time on or before March 18, 2011 for about $450. This limits your upside but guarantees an additional $450.
Volatility (Chicago Options: ^VIX) is low right now, this means options tend to be cheaper. Therefore, put protection is more affordable while selling calls doesn't generate as much income.
Prominent Support/Resistance
Support and resistance levels for stocks are like traffic lights for cars. Stocks are not guaranteed to stop at resistance or bounce off support, but like a car, if it's going to stop, it will be at a light.
If one light is green (support resistance is broken), the car is allowed to move on until it hits the next light.
Via its outlook for the month of November, the ETF Profit Strategy Newsletter highlighted the importance of the monthly pivot at 1,170. Pivots are support resistance levels and are derived by calculations of previous new highs, lows and the distance between them. Pivots can be calculated for hourly, daily, weekly and monthly time frames.
On November 7, the ETF Profit Strategy Newsletter stated that: 'Any correction that doesn't drop below monthly pivot will likely result in new highs.' Throughout November, the S&P retested 1,170 on five separate occasions, but never broke below it, resulting in a new high.
Using the monthly pivot, investors could have covered short positions, entered long positions, or bought puts right around 1,170.
Trailing Sell-Stops
Trailing buy or sell-stops are the most basic way to enjoy the upside and limit the downside (or vice versa). A trailing stop will move the exit price as long as the stock/index moves in the 'right' direction. Once it moves beyond your point target in the 'wrong' direction, the position is closed.
Trailing stop orders can protect you from a brewing storm, but can also get you stopped out at the worst time. Using pivots can increase the effectiveness of trailing stops.
Bernanke - A Disguised Bear
We've discussed various avenues to protect against an unwanted decline. Is such a decline possible, even likely?
If you haven't watched Bernanke's interview on CNBC's 60 Minutes, I encourage you to do so. Yes, Bernanke showed again that he'll unleash more QE if needed, but his assessment of the economy was outright disturbing for the bulls.
To rationalize QE2, Bernanke highlighted how bad things really are and that inflating asset prices via QE2 is about the only hope. Fortunately, he's about 100% sure that QE2 - and perhaps QE3, QE4, etc. - will succeed.
A 100% expectation of success from an entity with a flawed track record is not comforting, especially coming from someone who said in 2005 that a housing bubble 'is a pretty unlikely possibility' and therefore, failed to prevent the post 2007 crash. The odds are that the Fed is simply inflating a new bubble in an effort to rectify the damage of the previous bubble bust.
But you can't profit today on a bubble that isn't ready to bust, so we'll zoom in on short-term opportunities. In November, the S&P (SNP: ^GSPC) bounced off the monthly pivot at 1,170 and is rallying towards the next resistance cluster. With sentiment at multi-year extremes, the next level of resistance may repel stocks.
The December support and resistance levels are available now to subscribers of the ETF Profit Strategy Newsletter and will aid in assessing the potential up and down side for the next few weeks, providing an early warning system to protect against any unwanted surprises.
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