Did the Market just fake out everyone?

The market initially had the look that it was failing at resistance. It sold off sharply and screams that the top was in were showing up. Even I pointed out in the post "it's a trap!" that there was possibly a topping process setting up, but at a minimum the market was getting ready to trap someone. It appears for now the optimist was right.
There clearly appeared to be a topping pattern in place after what seemed like large gains from the low. But just then the buying pressure continued on and we now may get a monthly close ABOVE resistance for arguably the first time depending on how generous you are, or at least get the 2nd bullish close above resistance. We also failed to get a close below the steeper angled upward trend channel and prices rejected such an attempt. Even the monthly parabolic SAR hit stops before rejecting lower prices and rocketing higher as stops for many were taken out. The move from the recent low on a daily chart has been both awesome and horrifying. Even though we declined sharply the rebound has been even more steep and dramatic ensuring to trap every short, take out every stop and get the average joe to miss out yet again. Meanwhile the average Joe's asset of choice is gold and the panic in gold may be just getting started only AFTER everyone owning gold missed out on the chance to convert their gold to cash and then stock. The average JOE has not capitulated in gold yet, and they are still terrified of getting back in the market, so at best they will chase the rally higher later on... only after having missed out.
Of course, the possibility this break out fails still exists. If one believes that this is a breakout, he/she better have a plan to capitalize off of it in a way that offers an asymmetric return. Possibly waiting for a monthly closing below the overhead resistance which now becomes support before selling, and letting the winner ride to at least the upper end of the shallow trend channel before selling.

This type of action was seen only a few times before. There are at least 2 good analogs for how prices behaved. 1998 and 1996. Each were incredibly bullish. 1927 saw a similar pattern where it broke prior trend, it rejected, and rocketed through to new highs. But the idea is it set up a low, it took out a low and rejected it sharply while leaving long candles below also showing a sharp rejection.

The Secret To Wealth Generation: Asymmetric Returns

There are many secrets to generating wealth but in one form or another it is all about the asymmetric return. Asymmetric returns or asymmetrical distribution can be illustrated with a "positive skew" or what most people refer to as a "skewed right" distribution.  It can be done with a normal distribution or skewed left as well as long as the median is far enough above zero but that is less likely.





Over time trades have a slight skew right because wealth is generated over the long run. Stocks go through many cycles but the ones that outperform only need a slight skew over a long period of time to generate a positive return independent of your strategy. However, there are plenty of situations that you can create an asymmetric return on risk or what can also be considered "asymmetric risk".
Take for example the secrets of Warren Buffett. He did so many things well.
First he had a strategy that was going to provide him with an edge which produced asymmetric returns through outperformance in bear markets. (see bottom right)

He did this through having a portion of his account in what he called "workouts" which was "risk arbitrage" and "special situations" that would profit independent of market direction.

Second through his value investments and "net-nets" he was able to buy stocks well below intrinsic value or "purchasing a dollar for 50 cents" This on average both reduced risk and increased return and boosted performance in both conditions, but typically in the intermediate term still correlated with the market. (But due to his "workouts" he would be capitalized to add more undervalued stocks if the market declined rather than being forced to sell something undervalued to buy something more undervalued like most value investors.

Third he traded with other people's money and with a disproportional amount of someone else's money on the line he started a hedge fund where he shared in 25% of the returns beyond the first 6%.
Forth he merged the partnerships he had to buy Birkshire, a textile company that was priced well BELOW the inventory liquidation cost. (Buying $1 for 50 cents)
5th he liquidated the inventory and turned the company into an asset management company and
6th hetook the company public, selling 80% of the company at a premium to the public raising a ton of money while still owning 20% of the upside in the company's future return on his remaining stake.
7th he took the public shareholder's money and put it to work buying insurance companies that would continue to collect income and pay off his initial investment and
8th he invested the float of the available balance from the operating income. In other words insurance companies collect money monthly from the insurance and are sitting on that money before they pay out claims. Buffett took this money and put it to work
9th He bought good companies at a fair price like coca cola which would grow in value and continue to earn money over time and eventually the investment would continue to compound and the untaxed earnings would also compound if he didn't sell. The key would be to find a company unlikely to go bankrupt and that will also earn in excess of 100%. This provides a greater than 1:1 relationship between risk and reward.

Note that he not only had an asymmetric return in everything that he did, but he also found ways to get more out of each decision he made and create leverage without leveraging the risk.
Ben Graham would use Net Nets, he also liked insurance companies for the same reason Buffett did and Graham would also adjust his allocation to handicap market so that he had more towards investments when he had bullish expectation and more towards treasuries when he had a bearish expectations and he used an allocation strategy which over time produces asymmetric returns.

As a trader I use out of the money options which are all about the assumption that returns will be skewed towards one direction, and if you are right you can make many times the risk. The clear thing is that if you have an outlier to the downside, (say an overnight gap down) you only lose your initial risk. If you have an outlier to the upside (say an overnight gap up) you can gain ridiculous sums of money well in excess of your risk. Even without the outliers, the trading system is done where the underlying stock has a limited downside as it will be near support and the upside will be well in excess of that downside in around 80% of all cases. Another thing I do for the asymmetric return is identify stocks that have been hit with negative emotions and with tarnished sentiment that isn't beyond repair. People that get frustrated with the trade giving up for emotional reasons take a lot of the downside risk OUT of the stock independent of how stops are managed and the upside risk for shortsellers outweighs the downside risk providing the asymmetric risk/reward to the benefit of the trading system.

Volume profile also offer the psychological conditions for where the action required to drive the stock up or down is asymmetric. In other words, an equal amount of buying pressure will produce much larger price movement than the same amount of selling pressure. This is because there isn't the psychological price history to provide a backstop from stocks continuing their momentum to the upside, but there are plenty of past action below to potentially behave as support.

Finding stocks that are oversold by multiple time frames can also offer an opportunity where the downside risk has been largely sucked out particularly on high volume indicative of capitulation. However, often times the severe oversold indication will have risk to option buyers including high volatility and high premium cost that make capitalizing off of it using leverage a bit more difficult. However, looking at instruments like gold and oil and copper can provide a situation where even though the underlying commodity is oversold with high volatility, the individual stock may have low volatility, and in a much more manageable location.

Pairing Allocation Strategy With Trading Strategy

I've discussed in the past the benefits to pairing a trading strategy with an allocation strategy. Since then I have made some mental strides in conceptualizing how to discuss the advantages and some adjustments that can be made.

What it comes down to in taking advantage of and capitalizing from an option strategy is whether or not the cost of options is cheap enough to profit. When implied volatility is low, it is a situation where historically average (and above average moves) in the right direction will make you a disproportional amount of money to the risk you take if you are wrong. However, when implied volatility gets higher, it requires a greater and greater move above and beyond average to have a strategy that does more than break even. Although you may be able to develop a skill enough to the point where you can capitalize over the long run in low volatility and high volatility situations, for the time when volatility is high it becomes less profitable and at times unprofitable. Although you can profit from an allocation strategy over the very long run just from prices normalizing through high and low volatility situations it is less profitable when volatility is low.

The idea of pairing each strategy is therefore about reducing the negative effect that downward volatility has on your portfolio so you are better capitalized to recover drawdowns. Typically a 20% drawdown requires a 25% gain just to break even and a 50% drawdown requires a 100% return so the more volatile, the most costly the strategy is, even if on the other side of it you can gain with greater risks.

The other side of it is actually having MORE money on a system that works in the current environment and then being able to smoothly transition.

But the strategy doesn't need to use options. You can pick stocks and still help rebalance and adjust the position whenever necessary without negatively impacting your allocation to a position. If you have a bunch of stocks with a target of 30% and a downside risk of 10%, you don't want to have to reduce your position to half that when the stock is up or down. Nor do you want your entire portfolio and allocation to stock increase by nearly 30%. If you have a winenr, you also want to be willing to let it run if it reacts positively and continues to work beyond your price target. If you have a portfolio that is consisting of the same stocks and it is up a bunch, your allocation would otherwise be overly aggressive at any given time in a normal strategy. With the allocation strategy pairing it, you can simply reduce your stocks index allocation and maintain paritiy with the rest of your portfolio. Additionally, doing so with a stock index that is typically positively correlated with individual stocks (even if that correlation is low) means that you will TEND to reduce the position of the stocks allocation when prices are high, and add to it low. This is the opposite from a trading strategy which must cut losses lower than the purchase price as not doing so would prevent you from having a disproportionally large upside gain to downside risk unless you were to invest very long term and allow for many hundred percent returns like Buffett with coca cola.

The strategy also need not stop there. One thing I recognize is that when volatility gets extreme it can be awhile before your options strategy is profitable again. In the meantime it might be wise to bennefit from both normalization of prices and declining volatility AND having a product with a basic edge. the XIV product for example bennefits from the vix futures constantly being in "contango" except when prices get really high (typically above 30). Once prices fall below there the XIV will also have gone up in price anyways, and the normalization of prices over time even without rebalancing results in the XIV going up as does the length of time it spends in contango. So if the product survives you can make a lot with the XIV. Note that when the VIX moves sideways over a long period of time the XIV and other products are up considerably. It has a structural edge and the return can be well in excess of 100% while the loss can only be 100% So part of the strategy should not just be allocating to a stock index and adding and subtracting shares but permanently owning an allocation of XIV that increases when the VIX gets above 20 and decreases when the VIX gets to it's lower range. This not only will make money over time, but will put more on it when your edge is larger and it will also raise cash when your edge of an option trading system is larger so that you have fuel to keep betting on your greatest edge.

Finally, having CASH is necessary at all times. You may need cash to add to an allocation strategy that dips below a certain amount, particularly if you don't have another allocation that has grown to large enough to sell to raise cash. You also need cash to provide capital to add options into your account and sustain losses. You need enough cash so that your position size doesn't need to get substantially smaller after a handful of losses and you need cash to reduce the volatility as options and leverage can create lots of it. However, it may be on average quite some time before you use ALL of the cash. Enter INCOME.

The idea behind income strategy is not only having a constant flow of capital to normalize return and provide a positive return, but also is in recycling the cash that you have. If you accumulate dividends at a fast enough rate you can naturally have some rebalancing occur so that no position gets too large for very long and no allocation gets too large. If you get income fast enough, you won't need to reduce position size after you have sustained losses in your portfolio because the gains from the income will offset it (and from the allocation rebalancing).

Also, the stock market as a whole can be beaten either with increased returns over average on the way up and the same risk, or by reduced returns on the moves down with the same returns. Pairing each strategy so that you have a particular balance will allow for increased returns on decreased risk. Buffett is capitalized to always have the ability to buy and capitalize off of lower markets. Over the long term, bear markets will not impact him as much as others. However it is possible that in bull markets he will only match the performance of the S&P. Nevertheless, overall he should be expected to outperform and the added capital of the insurance business should make Birkshire Hathaway a good very long term investment. Applying leverage yourself via 2x and 3x ETFs or calls on the market can provide leveraged upside and if you can reduce the allocation on the way up it in theory could neutralize the downside, but using calls as leverage can make the downside manageable to where if it exceeds market's expectation the cost and downside is still fixed.



A hedge can still normalize your return and make your return on risk positive if done correctly even if it is only a break even hedging strategy or slightly worse. If it allows you to increase leverage without increasing your drawdown and the gains are in excess of the cost of the strategy, you still can gain. But mostly hedging is to naturally adjust to a sudden change in the market as the allocations of calls will shrink and the value of the puts and hedges will grow when market engages in a correlated sell.

Finally, Dynamic allocation where you take some liberties to handicap the market and have some skill edge may increase the volatility and risk depending on how aggressively you do it, but it may be worth the effort. You can increase the cash/currency/bond position if you want to reduce the volatility of the strategy.

Also, in the long run, balancing out the volatility of each asset so that you reduce the downside risk can be done if going forward the standard deviations of return remain reflective of the future. You can use tools based upon this theory to attempt to balance out the return so that you have limited downside and high upside with minimal volatility, and then consider leveraging up the strategy to boost the returns, or leveraging it down to reduce the risk depending on your goals.

portfolio visulizer is a tool where you can maximize sharpe ratio and sortino ratios

I am not sold on the theory behind this as I think even 50 years is not enough time to really get a sense for what can happen to assets. From 1940 to 1980 you might conclude that there can be no 90% decline in stocks while the bonds also eventually are liquidated and lose lots of value but if you look at the 1929-1933 that is exactly what happened. Just because a strategy is robust over the last 50 years doesn't mean it will be going forward. I think you have to anticipate relationships to some degree. However, you can still see that international small cap and small cap value where relatively effective in the past at reducing some of the risks of treasuries. If you think those risks are greater than advertised, simply reduce the allocation of them and increase the allocation of that which normalizes and neutralizes it. Just be aware that that may present other risks and you have to offset those.

I think understanding the nature of how rotations of assets and the right balance of ownership can compliment each other constructively provides for an interesting opportunity in understanding the nature of the markets, and how the sum of a portfolio parts can be greater than the whole. But the concept of game theory is what would say to me "if everyone positioned such that owning this allocation was advantageous there would be an over ownership in treasuries, and eventually it would reach a point where the least amount of selling can cause the most amount of pressure downward on price and the yield can go higher". Japan tried manipulating a market for a very lengthy time and it didn't work, so I wouldn't necessarily believe that the fed will be able to handle it and keep bond yield low. Plus pension funds may find it increasingly difficult to maintain high returns without rotating into risk which may have political consequences and pressure for rates to go higher.

However, it is still useful to understand how treasuries provided income that normalized a lot of the downward risk of smallcaps and how international exposure mitigated some of the risk of domestic smallcap value. And gold also provided enough of a boost in the late 70s to mitigate the loss of confidence in treasuries and slowing growth of the stagflationary era. That knowledge could be used to even attempt to "game" certain market conditions by tweaking the allocations, and the value of income can also be introduced and considered.

Although it is a bit difficult to map out a dynamic strategy that ADJUSTS as conditions change and much easier to illustrate a baseline the thing I think in the future I do want to incorporate is
1)I want lots of income and exposure in the private equity and business development asset class (enter BDCL and asset management stocks like BX). 2)I want the XIV to be used to capitalize off of high volatility 3)I want the option buying strategies to shrink when the VIX gets higher and the position size of options to increase as the VIX gets lower and decrease, and ultimately be eliminated as the VIX gets higher. I want the number of positions to decrease as correlations go up and as the VIX goes higher as well. I want to own a larger portion of birkshire when markets are more vulnerable to under performance and decline, and I want to increase allocation of BDCL and BX and private asset management stocks and/or leveraged ETFs (and possibly XIV if it will occur on falling volatility) when I suspect markets will outperform. 4)When volatility is LOW I will reduce XIV and increase the SPY hedge to mitigate the potential damages XIV may cause if VIX keeps going higher. When VIX is high and going higher I will increase the XIV position as I reduce the allocation of the hedge. 5)I will attempt to handicap the market and normalize the volatility in allocation strategy a bit but not too aggressively. 6)Corporate bonds. I am really skiddish ito invest in treasury or government debt right now as everyone has followed the model of the US which is aim to finance their way out of a financial crisis and borrow money to starve off recession which may put them at risk for being able to sustain the borrowing ability just as any market security can become oversaturated, so too can the government become too large and require too many taxes to operate and become too invasive in collecting taxes to the point where the people no longer tolerate it and/or the bond holders no longer can support the risk and the taxes going higher no longer creates higher revenue as increased taxes will just increase the people and capital fleeing and going off the grid and moving countries and using offshore accounts. There has to be a tipping point.

The adjustments will not be easy but I am thinking about something like the following:

VIX around 10 and under XIV 2.00% SPY puts 9.00%
VIX under 13.5 XIV 8.00% SPY puts 5.00%
VIX around 15 (sliding scale) XIV 14.00% SPY puts 4.00% VIX above 17.5 XIV 20.00% SPY puts 3.50% VIX above 30 XIV 25.00% SPY puts 2.50%

The strategy will then adjust the allocation of the XIV/SPY put hedge accordingly. So it will look something like the following:

	VIX around 10
XIV/SPY puts pair trade	11.00%	long term outperform
BRK/B	5.00%	long term outperform
IWM/SPY	1.00%	long term outperform
commodities	4.00%	commodities
bonds	5.00%	bonds
currency	7.00%	currency
1-2wk	5.00%	stock timing
3-4wk	11.00%	stock timing
5-15wk	6.00%	stock timing
15-40 week	6.00%	stock timing
40+wk	5.00%	stock timing
stock basket of 5 tops	0.00%	stock picking allocation to sector
income	2.00%	protection
cash	18.00%	protection
hedge	14.00%	protection
	100.00%
	VIX around 12
XIV/SPY puts pair trade	12.00%	long term outperform
BRK/B	3.00%	long term outperform
IWM/SPY	2.00%	long term outperform
commodities	5.00%	commodities
bonds	5.00%	bonds
currency	6.00%	currency
1-2wk	4.00%	stock timing
3-4wk	12.00%	stock timing
5-15wk	7.00%	stock timing
15-40 week	7.00%	stock timing
40+wk	5.00%	stock timing
stock basket of 5 tops	0.00%	stock picking allocation to sector
income	5.00%	protection
cash	20.00%	protection
hedge	7.00%	protection
	100.00%
	VIX around 14
XIV/SPY puts pair trade	15.00%	long term outperform
BRK/B	3.00%	long term outperform
IWM/SPY	2.00%	long term outperform
commodities	4.00%	commodities
bonds	4.00%	bonds
currency	5.00%	currency
1-2wk	3.00%	stock timing
3-4wk	10.00%	stock timing
5-15wk	5.00%	stock timing
15-40 week	5.00%	stock timing
40+wk	4.00%	stock timing
stock basket of 5 tops	0.00%	stock picking allocation to sector
income	10.00%	protection
cash	25.00%	protection
hedge	5.00%	protection
	100.00%
	VIX around 16
XIV/SPY puts pair trade	20.00%	long term outperform
BRK/B	3.00%	long term outperform
IWM/SPY	2.00%	long term outperform
commodities	4.00%	commodities
bonds	4.00%	bonds
currency	5.00%	currency
1-2wk	3.00%	stock timing
3-4wk	7.00%	stock timing
5-15wk	4.00%	stock timing
15-40 week	5.00%	stock timing
40+wk	4.00%	stock timing
stock basket of 5 tops	5.00%	stock picking allocation to sector
income	5.00%	protection
cash	25.00%	protection
hedge	4.00%	protection
	100.00%
	VIX around 20
XIV/SPY puts pair trade	24.00%	long term outperform
BRK/B	3.00%	long term outperform
IWM/SPY	4.00%	long term outperform
commodities	2.00%	commodities
bonds	3.00%	bonds
currency	4.00%	currency
1-2wk	1.00%	stock timing
3-4wk	2.00%	stock timing
5-15wk	3.00%	stock timing
15-40 week	4.00%	stock timing
40+wk	4.00%	stock timing
stock basket of 5 tops	10.00%	stock picking allocation to sector
income	5.00%	protection
cash	28.00%	protection
hedge	3.00%	protection
	100.00%
	VIX around 30
XIV/SPY puts pair trade	27.00%	long term outperform
BRK/B	2.00%	long term outperform
IWM/SPY	4.00%	long term outperform
commodities	2.00%	commodities
bonds	3.00%	bonds
currency	3.00%	currency
1-2wk	0.75%	stock timing
3-4wk	1.50%	stock timing
5-15wk	2.00%	stock timing
15-40 week	2.50%	stock timing
40+wk	3.50%	stock timing
stock basket of 5 tops	12.25%	stock picking allocation to sector
income	5.00%	protection
cash	29.00%	protection
hedge	2.50%	protection
	100.00%

alternate strategy when vix gets above 16 something like:

 

alternative
XIV/SPY puts pair trade	0.00%
BRK/B	0.00%
IWM/SPY	0.00%
commodities	0.00%
bonds	0.00%
currency	2.00%
1-2wk	2.00%
3-4wk	2.00%
5-15wk	2.00%
15-40 week	2.00%
40+wk	2.00%
stock basket of 5 tops	62.50%
income	0.00%
cash	20.00%
hedge	5.00%
	100%

(this is all more fo a guideline that you can deviate from according to how the market sets up but gives a bit more clarity when there is uncertainty about how to position.

It's a Trap!

There were only a few times in a long time of history where volatility has been comparable to the action over the last several weeks and months. I've heard of '98 being quite volatile and 2000 but I personally didn't trade then (well, I paper traded 199-2000).
One of the important mechanisms of the market is the "short squeeze" nd the "margin call" that causes very violent directional moves particularly when the large majority of capital is stuck on one side of the market with little action to support the otherside. Although amateurs might think having everyone bullish is good for the market it is the opposite as a certain inflection point occurs. At some point the inability for anyone else to come in and support the "bid" (because everyone is long and leveraged up as much as they can or are willing) means that the SMALLEST amount of selling pressure now means there is no one to buy lower prices left. stocks must continue downward until they find a  "bid" and that creates margin calls.
Margin calls are when people owe more money then they have and must sell shares of existing stock in order to either satisfy the margin requirements or get off of margin completely. If they don't volentarily sell enough by the end of the day the selling is then forced and the brokerage reserves the right to liquidate. When everyone is trapped long this can happen very quickly.
Often times there is substantial hedging that also may occur as markets begin declining from people who want to protect portfolio from further margin calls as institutions with hundreds of millions or billions or more under management cannot liquidate so quickly. At some point the selling pressure doesn't continue and at some point there are people that are the old men investors like Buffet that are patient that will step in and create a bid, and at some point the forced selling gets everyone off margin.

It is actually often short sellers that COVER their shorts and buy back their shares that often times helps to find a bottom along with value investors. That creates the second mechanism...
The short squeeze!
The short squeeze is the same concept but on the opposite side. those who sell short or that sell option without a hedge at some point are forced to "cover" or buy to prevent a margin call. The short squeeze occurs when there are many sellers that are short that now have to cover. Their buying and other buying triggers more short sellers that are above a particular price point in which they now must cover or risk the forced covering (or selling if they have hedges or long positions). This creates pressure points in the market that create FAST movement.
If you can learn to recognize WHEN and WHERE the players will get trapped over capitalized and unhedged, or undercapitalized and overhedged you can identify points in which market speed can pull a lot of people out and the market can run away in a trend in either direction.
Although every buyer technically has an opposite seller,, you still have points when those interesting in buying no longer can fund purchases, and points where those interesting in selling have either exhausted their shares or have gone short as much as their broker will allow(or as much as they are willing). You can recognize classic psychology of buyers and sellers and look at price and volume history for clues. The other thing that has a lot to do with future direction is market speed AND length of time trading at certain levels. The more speed and the longer the period of time traded at certain levels the more likely that the resolution will be of greater consequence. The breakout or breakdown at that point results in a huge number of people caught wrong and strong conviction on both sides now having to have one side admit defeat. Meanwhile, their conviction sometimes creates plenty of people reluctant to admit defeat. The more people that short a rally, the more fuel for short squeezes you will continue to have if the buyers remain in control. As I started this article saying, there are few times when the market has been as volatile as it has been. 2008,2009,flash crash,and the 2011 credit downgrade and then the recent action. In each case you had a huge shakeout. In 2008 on the way down there was some massive short covering counter trend moves that caught people on the wrong side. Initially the shorts covered and would then short again but many people got trapped trying to buy the dip and thinking the bottom was here trying to buy the rally. They had to liquidate on a market call once their stops got taken out. the flash crash a ton of stops got taken out and forced people out and then eventually the market was bought aggressively. 2011 flushed well beyond oversold and forced a lot of people to capitulate. I believe the major capitulation here is in energy and a bottom will form but I am not certain market will lead. This fast rip higher may be where many longs get caught. Or it may be all the shorts that got caught below that has provided additional fuel to keep this rally going. Unfortunately there is a high degree of uncertainty at any given point in time in the market, particularly with regards to WHICH direction. However, the one thing you can do is manage your risk which gives you an advantage over some of the big institutions that can't simply press a button and liquidate their entire position at the market as the market cannot absorb all of the shares and as they begin to sell prices will go lower and as they sell more prices will go lower and by the time they are out they would have sold potentially several percentage points below where the market price was when they hit the market order. At this location we very well could V reversal from the low and just keep on going. If/when we take out the prior high the market can gain additional momentum. I actually like hedging into strength here. As an options player, you can bet directionally and if you get a large move you can gain several times your investment and if you are wrong you only lose your initial investment. As traders you always want the reward to outweigh the risk. However, with options it is a lower probability system and you need to be right often enough for your large win to pay for your losses and then some. The risk and ultimately reward relative to your risk is highly rated to the cost of volatility. When volatility is high you need a larger move to generate the same return. For this reason option buying becomes more problematic. The volatility index is currently a bit rich but not excessively so. Betting on both directions on one particular stock via a straddle or a stangle however would be too costly as you would have to outweight the volatility cots on both sides. However, if you can manage risks and pick individual setups you may find that there are good setups on each side. One individual stock may setup such that if you are right you gain 3 or 4 times your risk due to a large upside move. Another stock may have its large risk to the downside. At this point in the market it is vital that you continue to pay attention to the speed and direction of the market and volatility but you look for asymmetrical opportunities of returns. If you trade stocks you might have a stop with a margin of error to account for volatility and have your upside represent gains in excess of your risk by several times. Currently I believe the market's best setup to anticipate at THIS particular location is a topping pattern because if you are wrong you can try to cut your losses, recoup some of your option premium, and it won't be too hard to flip. However, correlations ahve declined and individual stocks are setting up again to the long side so if we do break through you can still identify opportunity. Nevertheless with volatility more expensive, I would still suggest paying attention to the VIX and for now really limit your position size to maybe half that of normal conditions . It is very possible volatility will contract for awhile before the market decides on a move and that could mean losses on both sides or either side you play. Either have an edge on an individual stock and pick a side,or keep it small and continue to play allocation strategies while also considering a market directional hedge here. With the clear path forward signalling potential for major market direction resolving in the future I think SELECTIVELY option buying is still okay, although more difficult than usual and I would not consider trying options out here if I was not experienced in them at this time) Sometimes only time will tell what direction, and to some it may seem like a cop out to find a complicated way of saying "market will go up or down unless it trades sideways", but you can also handicap MAGNITUDE and speed and determine a spot where the upside if you are right about direction outweighs the downside, and how to act if it starts to play out a certain way. Similar to an allocation strategy, the idea behind a good trading strategy should be to make money over hundreds or thousands of trades without having to predict market or even stock direction with greater than 50% accuracy. Most of the time I don't care about what the market does, because unless there is a fast, correlated decline, I can still find which stocks that the market is rotating into and they should do well even in declines, or at least my losses should be small relative to the gains that I do capture so that over time I need not predict the market. However, market SPEED and volatility are very important as it indicates the risk of a correlated selloff AND indicates the cost of options and ability for option strategy to generate large enough returns to make the strategy worth pursuing.

Optomist vs Pessamist

Optimist

Pessimist

 The optomist views every recent low as support, the pessamist views every recent high at resistance and from which trend channels can be drawn parallel to those levels. The extreme pessamist may even suggest such extreme selling as the 2009 low as support even though it has no other reference points if it is parallel to resistance but that gives you a pretty wide range.
In the optimist view, if we don't reverse soon there will be re evaluation. In the pessimist's view even if we do reverse to the upside the upside still remains minimal relative to the downside despite the fact that the trend is still upwards until proven otherwise. The problem with both accounts is the optimist will draw new trendlines if we breach support where the pessimist will be in cash or short and could remain that way even as the markets continue to progress upwards near support for a very long time until the "support" is higher than current prices. You have to learn to evaluate both viewpoints and see the upside and the downside of each and come to some sort of consensus and gameplan to respect the overall risk and reward. You certainly could choose either viewpoint during points like right now when there is low risk entry. Right now being an optimist offers a low risk entry, provided you don't remain that way after support is breached.

Ford as an investment has great long term support around here and trendline support around $13 and horizontal price history offers support around here as well. If it does not hold, I would wait until around $10 to consider adding more.

Many energy names also look good.

Energy Time

As a trader, you tend to want to anticipate fast movements. As an investor you tend to want to look for value. As an option player you tend to want to sell premium high and buy premium low.
Right now I like selling premium in energy names as it capitalizes off of cheap prices that have undergone forced liquidation that is the driving mechanism which creates value. There are stocks selling 30% or more below where they were just a few months ago and the market determined in NORMAL conditions that the price was rational there. Comparing things to an "irrational peak" and declaring it on sale just because it is down 30-50% from the peak is not necessarily rational. However, compare where it was relative to the last irrational lows, and use sentiment and psychology in addition to any kind of fundamental analysis and you have a better chance at delivering a propper prognosis.

Was energy in a bubble? In terms of sector rotation energy is the last to outperform in a bull market and tends to continue even in bear markets. Financials tend to be the first to outperform and tend to get hit the hardest in a financial crisis. Right now there is no price action that looked "parabolic" in energy (although June looked a little bit overly enthusiastic) and the companies still have high cash levels. Energy (the XLE) also was barely above 2008 highs and is now below those highs.  There also is a built in mechanism where if energy stocks can't grow as a result and aren't able to produce as much energy the supply of oil tightens (assuming demand remains the same) and so price of oil must eventually rise. If things get worse and energy companies go bankrupt, that would be even more bullish as the decreasing amount of energy companies have more market share to obtain on average.
I believe the price action was first rational sell off due to sanctions on russia in the US and europe but then lead to forced liquidation which is rational in the sense that people don't want to owe more than they have, so they must sell to avoid margin calls and as a result prices may drop quickly which forces more margin calls and stop losses. While there is no telling how much further prices go, it can be ascertained that people don't necessarily want to sell, it just is better than the alternative in their situation. The forced deflation due to sanctions on Russia may cause damage, but eventually CHEAPER OIL will provide stimulus for those that use it the most which means increased capital available to businesses and consumers. Additionally, conflict raises the chance of wars, which can eventually trigger higher prices. Russia is very dependent upon oil for their economy while the US benefits from oil substantially WHEN prices rise to high enough levels as due to hydrolic fracking they are on pace to become the #1 producer in oil in just a couple years. However, US also benefits from low interest rates and has a very large part of their economy in technology and financial industries hich are in great position to profit from these conditions. The growth of business triggers growth in energy demand typically as it provides more jobs and causes more people to drive cars more often and require gasoline.

It is of my opinion that there are multiple tail winds ahead for the energy sector.

With implied volatility high you can sell puts and effectively promise to pay a particular price if you still hold the contract at time of expiration and that contract is below the strike price and get paid for that obligation. So you may wish to sell a contract at the strike price of your upside target in a year and promise to buy it at that price and you will get paid MORE than the difference between the current price and the strike price. You will be forced into the shares should the price not rise above that, but should prices go up or remain flat you still make money, and if they go down you get it at a slightly lower price than if you just bought the shares now. However, it is not as easy to sell so you must be thinking long term. OR you can instead choose to use it as effectively a limit buy order that may not get triggered if prices only momentarily cross below and then rise above that price but you will get paid for your obligation to buy at that price. The key in selling options is that implied volatility must be at a historic highs or relative highs and you must be able to tolerate the risks that come from the stock going to zero, AND you probably should also set aside the capital needed to buy the shares that the contract obligates you for (usually 1 contract for every 100 shares). The alternative is just buying the shares if you like the company, the price, and can mange the downside through sell orders. Additionally, if you choose to sell option to open, you can always buy it back to close... but keep in mind that the price of the option could go up and so there is the possibility of loss should you terminate the contract early.

Warren Buffett sold S&P puts in 2008 or 2009 that he locked in and acquired capital. He effectively bet against the S&P going below 650 and implied volatility was near it's highs so he got paid quite a bit. Since he was correct he was able to use that capital to buy and make money on additional shares and if he wanted now he could effectively buy a put to cancel out the risk at much higher stock prices (which equals much lower cost than he sold them for which provides profit between the two plus what he may have made from putting that cash to work). historical extremes can be looked at as "mispricings" seperate from the mispricing of the individual security. So when you can identify mispricins on BOTH the asset class it represents AND the cost of the option itself, there is tremendous opportunity if you play it right.

Option Addict posted some good energy ideas and reason for the theme here.

Risk Ladder

There is something known as a "risk ladder" that when "risk is on" you will see "climbed". In other words, investors seek risk when they expect monetary and credit expansion and when they foresee capital outflows from bonds and cash and think it will seek some sort of return. Then they may "go down" the risk ladder or move towards "risk off" when they seek protection of capital and have faith that bonds will hold the principal. You see this in more subtle ways on a short term time horizon that sometimes provides clues as to where we go next, but the longer term allocation money always will override the shorter term shifts.

The view shown in the bottom left corner of the picture may provide actionable information on the long term time horizon because it eliminates the noise but the picture above doesn't completely tell the whole story. For risk exists in far more ways than just asset wide, but it exists WITHIN an asset class, sector, and even industry between individual stocks which allows the more subtle movements and complex rotations that can be recognized, and there are cycles of sentiment that exists within individual divisions of an individual company and earnings within individual companies and then the greater and greater collective earnings picture as well as capital flow cycles and rotations.

There are various elements that may be considered a greater "risk". There is risk of the underlying company, there are risk of movement of the stock price, risk of changes in dividends. There are risk of accounting fraud, changing in management,FDA approval/denial, etc. There are risks from chasing a stock of an eventual pullback, or buying a dip that your position will continue it's direction so that you may capitulate before it turns around and goes higher... But I think the risk most overlooked by the average joe are how liquidity concerns and risks influence decisions by the professional large institutional money manager.

On the short term, you have risks of institutional clients who can still move markets, but the pension funds, the soverign wealth funds and the international and extremely large institutions and investment banks and companies and mutual fund managers of varying sizes make up the larger trend at work that also triggers collective action of the shorter term motions. Thus a panic is like a school of fish, trigger just a few leaders and they all start moving as one without knowing why they just react.  You have to learn about all individual components within the stocks so when you begin to see early signs of panic you can move ahead of the MAJORITY even if you are a little bit late, and at times you have to anticipate the move even though you will occasionally be a lone fish and be wrong and have to join the school for awhile yet again.

It is one thing to understand cycles, it is another to understand the "optimal strategy" to capitalize off of rotation or more specific cycles to handicap and exploit individual cycles... and how and when to deviate from that "optimal strategy", but that is another story. For now just understand that certain instruments represent risks and try to see the ebb and flow between them as indicators on varying time frames. Also learn how to understand volume profiles and how crowd psychology can be anticipated based on varying degrees of aversion to pain and tendency to defend price points and where the crowd will generally begin to experience "pain". When it comes to pain everyone has different thresholds before they can't handle it anymore and move on, but there is  tipping point in which a highly likely domino effect takes place and one sale leads to lower prices as there aren't as many buyers from below with the psychology to rush into buy relative to the number of sellers above which creates fast movement of prices. Combine that with the knowledge of the ebb and flow and the signs provided by instruments on varying levels with varying degrees of importance and you should be able to handicap the market more accurately through intelligent objective analysis.

No Breakdown yet, Still Bull Market

Russel teetering on edge but still no confirmed breakdown.Additionally, the other indices have not yet made equal lows which would be required before the next bounce should be shorted in 1-2-3 reversal. With the other indices not corroborating the story, this still should be looked at as a temporary correction within a bull market. In fact, I would expect the breakdown attempt to fail and at minimum first see a lower high before the russel breaks down.
edit:It looks like market is confirming the correction, but I will expect a bounce first before another leg down as we are too oversold here to present a bearish opportunity. So expect a rally that will be short lived and then a selloff into November, and then we may be able to find support and a great buying opportunity as everyone believes a more substantial correction and longer term bear market is here.