The Luck of the Irish

In today’s feature the “Luck of the Irish” will hopefully mean that we can make some green (as in backs) from today’s trading strategy. The markets have been more volatile in both price and volume lately, for good reason. Geopolitical events in the Middle East and North Africa are becoming more widespread. The Japanese crisis is more uncertain with each passing day.

On a technical basis, all the major market indices appear to have broken their up trends and recent support levels. Because markets rose at such a fast past since the beginning of September, there is very little support between here and their respective 200 day moving averages. This could mean there is more downside to go before reaching next support.

There is a lot riding on the depth and duration of this correction. The primary reason the rally started was that traders felt that the Fed had their backs in a sense. As Ben Bernanke outlined his Second Quantitative Easing Strategy (QE2), many traders did a little math and recognized that $4 to $5 Billion of new money was going to move from the Central Bank to Primary Broker Dealers on a daily basis for the next nine months.

The Fed monetizing debt, while simultaneously pumping banks with a plethora of cash, gave a level of comfort to traders that the stock market would be a one way street up. Until mid February, that has been true. The VIX “fear index” dropped below levels of complacency not seen since before the 2007 Great Recession began. Optimism among both institutional and individual investors held bull to bear ratios at extreme levels for extended periods.

It almost felt like the golden age of investing was back, as the “mom and pop” investors who missed the double off the bottom over the last 20 plus months started to come roaring back in. Now that the belief that the Fed can print our way into prosperity is coming into question, a vacuum of confidence could occur.

In the near term it appears that the market has more downside to go as support has been violated. Using one of the oldest and most actively traded ETF’s the SPDR S&P 500 (SPY) to create a synthetic short position by Selling an April 125 Call for $4.24 and Buying an April 125 Put for $3.37 per contract could be profitable in this environment. In this example you start by pocketing $87 per contract immediately.

A couple of technical analysis methods point to SPY having a near term price target of $119. Two reasons: First, that is where its 200 day moving average is. Second, this run started at the end of August with SPY trading at $104.29. It reached a high on February 18th of $134.69. A normal 50% Fibonacci retracement puts SPY at $119.49.

Should this happen in a week’s time this trade could result in a profit of approximately $650 per contract. The risk comes into play should the market move up quickly. SPY closed yesterday at $126.18. Should SPY trade here or lower this will be a good trade.

If you currently own shares of SPY, employing the same strategy creates a collar on your position and is an even lower risk trade should the market recover as your exposure is limited, but so is your return.

There are many reasons to believe that the market could continue in its downward trajectory. Not only are markets ripe for a pullback, should it start to accelerate down, a generation of investors will be lost as they throw in the towel quickly and the confidence of even most astute investors could be shaken. If that happens SPY could overshoot $119 making this recommendation even more profitable.