Option Investor
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Even in weakness there is strength

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Yesterday's trading did see a net loss of stocks on buy signals as it relates to point and figure charts in the NASDAQ-100 as supply once again is back in control. While this is a sign of short-term weakness as we chart this relationship between supply and demand we find strength. This can be confusing for many traders, but when you begin to understand the dynamics of supply/demand and how to measure it a trader begins to ascertain the internals of the market and how things are shaping up. Any type of technical analysis is more of an art than an exact science, but I do think the bullish percent chart of the NASDAQ- 100 ($BPNDX) from www.stockcharts.com tells us how much repair is actually taking place for stocks in this index. A trader can emphatically say that there is currently less risk in the NASDAQ- 100 today than there was in early May. If you think like an institutional trader managing large inventories you do like what you see for the bullish percent in the NASDAQ-100. Notice how different the action has been since May (red 5 on chart) as it compares to the past.

NASDAQ-100 Bullish Percent - 2% scale

In the past several months, the bullish percent for the NASDAQ- 100 had a habit of running to the 70% level or higher (overbought) and then immediately turning south and plummeting to below 30% (oversold) and staying there for a couple of months. However, a trader that understands buy/sell signals and the bullish percent (a basket of stocks where we simply separate the stocks in the basket by "buy signal" and "sell signal") and chart that value begins to understand how an institutional trader views risk. When risk is high (bullish % above 70%) a market maker or specialist is looking to rid his/her account inventory of risk and sell into a seemingly bullish market. When risk is low (bullish % below 30%) the market maker begins to once again build and inventory as many market participants begin to get nervous and sell their stocks after a decline. I've scribbled on the above chart what I would like to see happen as a trader waiting to get long. This would be Jeff Bailey's "best case" scenario for the bullish percent as it relates to a low risk/high reward type of trade in the QQQ and many stocks that make up this index. I want to point out that even though this indicator should have bullish trader's being cautious in their trades as the bullish percent is showing weakness. I do find that the consolidation that occurred above the 70% level as an indication that there was a prolonged period of bullishness for stocks in this index that we haven't seen for months! We can then draw a conclusion that what was happening in late April and early May (red 5) was that market makers simply didn't have enough inventory during that time period to feed into the market. That makes sense perhaps as it relates to recent indications from the bullish percent and the consolidation shown from the 42-50% levels as market makers try to add some bullish inventory at current levels and even cover some shorts they were forced to implement for those stocks that they did not have sufficient inventory.

That's right! Market makers will short a stock! Not because they are bearish on the stock, but because they HAVE TO in order to provide liquidity to the markets. Some people think that the commitment of trader's report that comes out is only an indication of bullishness and bearishness. I'd say FORGET what you believe and trade what you observe. I could easily argue that an increasing short position in the COT is created simply because some commercials underestimated coming demand for stocks and were forced to short stocks that they did not have inventory in. I've said before that market makers MUST provide a liquid market in the stock they provide a market for. They MUST buy and they MUST sell stocks in order to provide liquidity under ANY market condition. One subscriber recently wrote us that the COT shouldn't be followed as the commercials have been short for months but the markets haven't collapsed. I think the subscriber is thinking in the right direction, but was only thinking of the COT as a bullish/bearish indicator and not fully understanding the laws of supply/demand. Something to think about at least.

What a market maker is probably doing

I believe that market makers right now are trying to build some inventories as they got caught a little light and perhaps short in early April. However, I do think they will only be sitting some bids and trying to get stocks as cheap as possible. They will hold short positions in stocks that just are finding little interest (networking stocks come to mind). I do believe yesterday's reversal in the market was due to a large unwinding of some option hedges and market makers were "forced" to take the other side of the trade, thus the rally. For instance, if I had written a bunch of call options on the QQQs due to the fact that I was holding a large long position in the underlying security and unwound (or bought back those calls) my covered calls on the recent pullback, that could very well have created short-term demand. Especially if I'm looking at the bullish percent for the NASDAQ-100 and understand that its level has come down considerably in the past couple of weeks. If a market maker is trying to get some inventories built, he/she may not be wanting to have to sell those inventories, but instead turn to the market himself and offset that call option he just had to take the other side of the trade for. Does this make sense? If I'm a market maker on the call option and somebody comes to me and wants to buy back all their June expiration call options they sold in early April, the buyer of the call is closing that transaction, but the market maker of the call might be short and then go in and buy the QQQ to offset his risk. He doesn't necessarily buy the QQQ because he thinks it's going higher, but only because he she is trying to offset the risk he assumed as the options market maker. Not a bad idea especially when the QQQs were down 2% at one point and there were some eager sellers in the market.

Jeff Bailey
Senior Market Technician

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