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Worst Case Scenario

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If you've been leaning bearish on the Insurance Sector Index (IUX.X), the good news is that the group gave a sell signal early Tuesday; in fact, it broke below two short-term lows. The bad news: It rebounded after giving the sell signal.

In all honesty, I didn't expect the IUX to generate a sell signal so quickly after profiling the index over the weekend:

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But, I didn't expect the broader market, as measured by the S&P 500 (SPX.X), to pullback with the magnitude that it has so far this week. And it's been the broader market that has been the root cause of weakness in the IUX thus far. I wish that were not the case. I wish the IUX would demonstrate more non-systematic weakness. But it's not. And wishing is for wells, not me.

I know that the market has been the source of the IUX's weakness because on Monday, the IUX didn't give up any relative strength versus the S&P. In fact, the group slightly gained some strength. And Tuesday's rebound added more relative strength to the IUX, too. That tells me that the only reason the IUX traded lower Monday was because of the selling in the broader market. I would prefer that the IUX trade lower on its own merits. The best case scenario would be for the IUX to trade lower while the S&P moved higher.

But the IUX set-up is not currently a best case scenario. The reason for that is because it gave the sell signal with its breakdown below the 700 level Tuesday morning, completing the bearish triangle, but gained strength later in the day. So, if you shorted the breakdown, or bought puts, then you're in a sector that is gaining relative strength.

The formation of the triangle last week and subsequently generated sell signal Tuesday morning is reason to have conviction to the downside in the IUX. But a good trader, err, great trader, always balances his/her conviction with risk management. It's easy to be wrong in the market, but it's harder to admit that much, and hardest to do something about it.

One way I suggested trading the IUX set-up was through a straddle or strangle on one of the components of the sector, such as Chubb (NYSE:CB), American International Group (NYSE:AIG), Hartford (NYSE:HIG), and St. Paul (NYSE:SPC). If a straddle or strangle was put on Monday, or Tuesday morning, then the late day strength Tuesday shouldn't be a cause for concern, especially if the straddle or strangle goes out several months because I still think that the IUX is going to make a big move over that period.

Those who put on a bearish trade, however, on the sell signal Tuesday morning could be viewing the late day rebound as a most disconcerting development. I have two ideas to protect against any further upside for those with open bearish positions. The first way is to have a pre-determined level in the IUX at which to cut losses short.

If the rebound continues across the market, I could foresee the IUX moving up towards a resistance range between 715 and 720. IF the IUX is going to head lower over the intermediate-term, I would think that it would encounter resistance between that range and possibly rollover.

However, the IUX won't go on a buy signal, based upon the current set-up, until the 730 level, which is obviously quite a distance away. Remember, the IUX had been on a buy signal for the past month up until Tuesday morning, when it generated a sell signal with its break below 700.

IUX.X 60 minute

The 715 to 720 resistance range and the 730 level can be used as levels at which to manage risk in any open bearish positions. Either level could serve as a mental stop and a point at which to cut losses short. Yes, both levels are quite a distance from the 700 sell signal level, but you have to give a trade room to operate.

The second idea for managing risk in open bearish positions is to leg into a bullish position, in doing so, entering a straddle or strangle. Ideally, a straddle or strangle is put on with the bearish leg near resistance and the bullish leg near support. That way, a trader can capture the spread between the trading range and have all the more profit potential on the breakout.

Obviously a trader who entered a bearish position on the sell signal at 700 Tuesday morning entered near support, or what had been support. As such, legging into a bullish position around current levels in the IUX would create a scenario where the trader would lose about 8 points in the IUX to the upside. But it would still offer upside protection in the form of a hedged position.

Tuesday's rebound following the sell signal may prove to be nothing more than noise; an attempt, by the market, to make this trade more difficult than it needs to be. The market has an uncanny way of complicating simplistic trades by injecting emotion into the situation.

With that said, it's important to focus on the fact that the IUX gave the sell signal Tuesday morning. In doing so, the IUX broke down from its triangle and created a bearish triangle. And that was enough to have conviction in the trade and reason to enter bearish positions. That was the right thing to do! But as I previously wrote, even with a lot of conviction, a trader absolutely has to manage his/her risk in a position, no matter what.

Eric Utley
Option Investor

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