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NASDAQ ready to re-test lows\?

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I've lost track of the number of "alerts" the NASDAQ Composite has given to the downside in the past couple of weeks. It's been a trader's market and looks like it will continue to stay that way.

NASDAQ Composite Index Chart - 60-minute interval

The NASDAQ has had trouble trying to hold levels of "support" on our retracement bracket since we put it in place a couple of weeks ago. There has been little reason (other than perhaps market history) to get long this index. Today the downside continues.

Retracement levels

Using retracement levels is more of an art than science, but here's my two-cents worth. Basically, I believe that professional traders and market makers trade levels and monitor trends. The retracement bracket addresses "levels", but more in terms of "percentage retracement" than anything.

Imagine if you will that you are a market maker. SEC rule says that you MUST provide a liquid market for investors to buy and sell their stock. If you're going to make a market and benefit in the spread (your reward for providing liquidity to the market) you MUST provide liquidity and be firm at your stated bid/ask. Remember, you don't have a choice in buying if you are displaying a bid, you MUST provide a liquid market and at any point in time be available to perhaps buy/sell 1,000 (SOES can hit you with 1,000 shares) shares of JDSU if you are the inside bid/offer.

Now that you know the rules you MUST abide by, what is your biggest concern? Risk right? RIGHT!

OK, let's say that you decide to start making a market in JDSU on 10/2/2000 when the stock is trading at $90. Up until now you have not been making a market in JDSU, but your firm likes the volatility of the stock. The firm likes the $0.25 and $0.12 spreads and figures it can make a killing trading 50,000 shares a day and keeping the $0.18 (on average) spread on every share. Let's see... that is 50,000 x $0.18 = $9,000 a day in revenue, assuming no gains or losses in inventory! This is what management looks at.... now it's turned over to you. Just don't "mess up" and cost the firm any money in the form of losses!

OK Mike/Molly, go make a market, but don't get on the wrong side of things. All management asks is that you go in there and get that $0.18 spread on every share, but control your risk!

OK, now pull up a chart of JDSU on a daily chart. Just for simplicity sake let's use our retracement bracket with the settings at 100%, 61.8%, 50% 38.2% and 0%.

JDS Uniphase Corporation Chart - Daily Interval.

Now, onto our lesson. The evening of 10/2/2000 you start planning how you're going to manage your risk in JDSU as you begin building an inventory. Since you have no inventory you start buying the stock so you'll become a bidder on 10/03/2000 and show a bid size of 5,000 shares at $89. Now you know all about trading levels and risk/reward so you take your retracement bracket and "snap" your anchor point to the high of 7/26/00 at $140.50. Let's imagine you remembered the firm's guidance to you of not "messing anything up" and taking a huge loss so you set the 50% retracement level near the recent low of 10/2/00. Hey look there! Our 38.2% level also correlates nicely with the lows set back in April to June!

OK, now that you have the 100% level up at $140.50 and the 50% retracement near $89.25 you're ready to start taking inventory at $89. Now.... where are your 61.8% and 38.2% retracement levels? Remember that all you have to do is control your risk and monitor levels. The 38.2% level is at $76 and the 61.8% is at $100. Immediately you might say, "Look, I'm a buyer of 5,000 here at $89 and the firm has given me $4.5 million as capital to trade." At the end of the month Mike/Molly, you'd better have at least $4.5 million worth of stock or capital combined or you're out of a job. With that in mind, you also attach some "labels" to your retracement levels. You are just sure that you will be buying a new Mercedes if you build an inventory near $89 and that inventory is near $100 at the end of the quarter. You also feel that you might just upgrade to a Ferrari if that inventory is worth more than $100. Let's see... $4.5 million divided by $90 a share is equal to 50,000 shares. And 50,000 shares with a $10 profit would be a $500,000 profit in inventory for the firm. Yep, they'll give me a $50,000 bonus for sure! Now, I could lose country club privileges if I'm carrying inventory below the 50% level and might just lose my job if it ends up below the 38.2% retracement level, so I'd better be willing to short the stock at times just to make sure I protect the firm and my job. OK, let's get in there and make some money!

JDS Uniphase Chart - 15 sessions later.

Have you read the book "What Color is Your Parachute?" Here at $101.18, management is very pleased with your performance. You're carrying 50,000 shares of JDSU in inventory, representing a paper gain of roughly $400,000, not to mention the revenue generated from market making activities at 12 cents per share on 15,000,000 shares. Wow! Another $1.8 million. Now, understand this is just an example, but look where you are making your money. However, if you understand risk right now, what's your risk? Your ultimate risk is 50,000 shares at $93 or $4.65 million!

Mercedes or Ferrari?

Now comes the time for you to make a decision. Management is very happy with your performance and wants to know what color of Mercedes would look good in your garage. Do you want a Mercedes or Ferrari? If you want a Ferrari, JDSU has to get through that downward trend just above at $107. It's your call. Do you sell some inventory today and walk away with a Mercedes or hold on for that Ferrari?

JDS Uniphase Chart - Very next session.

Now that I've seen the Mercedes go "poof" as I was getting a little greedy and going for the Ferrari, I need to lighten up on some inventory. After all, I'm carrying $4.65 million of risk!

JDS Uniphase Chart - 15 sessions later.

It doesn't take long to see how monitoring levels and controlling risk can help keep a trader gainfully employed. You would have had some explaining to do if you were still holding 50,000 shares of JDSU at $93 in inventory. If you were still holding 50,000 do you think you might be selling a rally here or perhaps writing a covered call and buying a protective put? What if JDSU falls to $36? As a trader that manages risk, you've learned to not use the words "never" and "always". Let's also "pretend" that we know something about "waterlines" and what to be doing when we are above or below them. Just as we were building an inventory near or above the waterline (50% level on our retracement bracket) we are now leaning toward the building of a short position. We can do this with our market making activities by selling 1,500 at the offer for every 1,000 we buy at the bid. The key is to monitor levels and control our risk.

JDS Uniphase Chart - months later.

Since your decision to start shorting 1,500 shares at the offer for every 1,000 shares you bought at the bid in your regular market making activities, management has taken notice. Not once did you look at the company's fundamentals or growth rates. All you did was manage levels and assess risk/reward and follow prudent account management rules. Not only that, but you traded with the trend.


When we first started making a market in shares of JDSU at $90, we attached different labels to "reward." We passed up a Mercedes on the "buy side" as we were going for the Ferrari and perhaps $120 or $140. We understood there was a wall called "downward trend" between the Mercedes and the Ferrari. Once we understood risk/reward and levels from the retracement bracket we soon became a seller as the risk of losing our job wasn't worth the reward, which we had already passed up at the $100 level. While the MARKET made the ultimate decision for us, we just monitored trend and levels. In the end everything worked out fine. While we didn't get the Ferrari at the $140 level, we did get it at the $36 level.

Think like an institution!

Next time you're driving on the interstate or around town try and observe how many people are driving a Mercedes or a Ferrari. While the car a person drives by no means makes the person "successful" it may say something about the amount of risk they've taken in life and how they manage that risk. The person that drives the Ferrari might be perceived as a "high roller," but they might just be very good at managing risk and participating in trends! Remember that the trader/investor that bought JDSU at $90 was thinking "Ferrari" just like the trader/investor that shorted the stock at $75 was.

Want to know how to trade JDSU from here on out?

Using the same technique we started with on 10/02/00 it's time for you to get to work and make some money for the firm and think like an institutional trader. You have a "goal" and that goal might be a Ferrari. Lets make things tough and pretend you're long 100 shares of JDSU at the waterline (50% retracement bracket) at $37. Perhaps there are some market makers with inventory at that level too.

Jeff Bailey
Staff Analyst

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