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Educational Article

Setting Up For MOPO

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In Monday's article, we spent some time addressing the question of whether it is time for to start sharpening our claws for another exhilarating ride down the charts. After looking at a long-term chart of the SPX and supporting charts of some of the additional indicators I use for assessing the likelihood of a trend change, I came to the conclusion that we can sharpen those claws, but we better not slip them on just yet.

If you missed that discussion, click on the following link to catch up.

MOPO - Remember That Term?
http://www.optioninvestor.com/page/oin/education/traders/2003/04-28.html

I'm going to go light on the charts tonight, as those posted on Monday really haven't changed much. But I do want to take a more detailed look at the SPX chart. Actually, we need to look at two separate views in order to show all the important details.

SPX Daily Chart -- View #1

Here we can see that the $920-925 area at the top of the descending channel is presenting a stiff obstacle for the bulls. But at the same time, each failure is being bought at progressively higher lows. In fact, bulls are likely encouraged by the fact that the past couple days have had the bulk of price action (and the closes) above the descending trendline from the August, November and January highs. Clearing off the chart and applying a different set of lines gives us another picture of the battle that is currently underway.

SPX Daily Chart -- View #2

As the battle over SPX 920 continues, we have a pretty mature bearish ascending wedge in progress. It comes to an apex near 932 (right at the January highs), but there is a slight problem. Bearish ascending wedges that are going to break down in textbook fashion, typically do so about 2/3 of the way between the beginning of the pattern and its apex. As you can see, we are right at that point in the pattern, with the wedge approximately 7 weeks old and only about 3 weeks left until the apex is reached. A break from this wedge should occur in the next 2-5 days in my view.

But wait a minute, you say. The VIX hasn't yet fallen into the 19-21 area, the SPX Bullish % is still rising and is not yet in overbought territory. How right you are! See, the price chart of the SPX is telling us that it is at a critical inflection point, but we don't have enough evidence yet to tell us that down is the high-odds bet.

I think there are a couple different ways this might play out. The first scenario is that the SPX does fail to push through the top of its channel and we get the bearish breakdown below the bottom of the wedge. Such a development should have the index vulnerable to the bottom of that wedge pattern near the $790-800 level. But that breakdown would not be the high-odds MOPO trade that we're targeting here. It could make for a very nice downside trade, but remember, we're looking to have several disparate indicators all tell us to play the downside -- that we don't yet have.

While I don't know what the probabilities are, the better setup for a MOPO trade would be to see the SPX push through the top of the ascending wedge, possibly into the $935-940 area. At the same time, we would likely see the VIX falling into the 19-21 area that has always signaled an impending market top. But we still have the issue of the Bullish %. Looking at it on the PnF chart, we can see that the bearish resistance line comes in at 65% currently. While we're still a ways from there at 56%, I can see where a rally to the $940 area would bring with it some internal strengthening that ought to have the Bullish % approaching that 65% area.

This is where the SharpChart version of the Bullish % is so useful, as it really gives us a quantifiable measure with which to gauge that turning point in the Bullish % that might not show up quite as readily on the PnF chart. We have two things to watch for on that chart -- the first is for the Bullish % line to cross down through the 10-dma, while the confirmation comes from the CCI oscillator dropping below 100 and then crossing the zero line.

So let's see if I can put it together in a summarized form.

Case 1:
The SPX confirms the bearish ascending wedge with a break to the downside, but the VIX never drops into that 19-21 range. Partial positions could be entered on the break from the wedge ($900 at this time), but prudent traders would wait for confirmation from the Bullish % SharpChart before rounding out to full bearish positions.

Case 2:
We get an upside breakout through the upper bound of the descending channel and through the top of the ascending wedge pattern. TAKE NO ACTION on this move. If there is to be a bearish resolution, it will happen when the SPX breaks back down into the wedge and out the other side. That would confirm that the breakout was a bull trap. It is on the break back down through the bottom of the wedge that we can get serious. What I like about this scenario, is the upside break would likely get the VIX closer to our desired action zone (making the options a bit cheaper as well) and have the Bullish % advancing closer to that 65% area. If we got a VIX down in the 19-21 "action zone", I would consider initiating partial bearish positions in the $930-940 area (see resistance zone laid out on the first chart above), but wait for a break below the lower bound of the wedge in addition to a cross of the Bullish % line back under its 10-dma before rounding out to a full position.

Alright, now that we have our scenarios laid out for initiating a MOPO trade, we have to decide on what vehicle to utilize. Should we focus on the SPX or how about the DOW or the NASDAQ? What expiration month? What strikes? So many questions...

First off, I would eliminate the NASDAQ or QQQ from consideration. This isn't so much because I don't expect the NASDAQ to fall with the rest of the market, but because I think its downside is more limited. I went into my rationale behind this belief in a couple of articles I wrote at the start of the year. Here are the links in case you missed them.

'Tis The Season
http://www.optioninvestor.com/page/oin/education/traders/2003/01-06.html

'Tis The Season, Part II
http://www.optioninvestor.com/page/oin/education/opt101/2003/01-08.html

So that leaves us with the DOW or the SPX. There's no reason why the OEX couldn't be used as an alternate to the SPX. To me, this is a matter of personal preference and account size. Smaller accounts will want to focus on the DJX because of the lower cost per contract. This allows for legging in and out of the trade with multiple contracts while still remaining within the confines of the money management guidelines laid out in your business plan. Larger accounts will want to focus on the SPX or OEX so they aren't having to deal with excessive commissions or large order sizes. My personal preference is to trade the DJX, but that is a decision based more on personal comfort than anything else.

How much time? This strategy is a bit different than the MOCO strategy we've talked about in the past, as market reversals from low extremes on the VIX tend to take longer to work than those that occur from VIX high extremes. Look at a daily chart of the SPX or DJX from last year at this time. While the VIX low was reached in late March, the first leg down completed in early May (6 weeks later), but the real payoff came in July, 4 months after the VIX low. For that reason, I would err on the side of caution and buy at least 4 months of time, preferably more. I like the September expiration for the best odds of minimizing the issue of time decay while we let the trade work through the summer doldrums.

The issue of which strike to buy is rather difficult right here, because we don't really know where the market will be trading when we get our entry signals. So rather than specify exact strikes, I think the best way to set up the trade is by selecting strikes a defined distance from current market value at the time the entry signal arrives. We're buying plenty of time, so we want to make leverage work in our favor by going with Out of the Money strikes. For the DJX, I would go 4-5 strikes OTM, while for the SPX, 2 strikes OTM should be optimal. For current levels, that would mean using the DJX SEP-80 Puts, or the SPX SEP-850 puts. You can adjust the selected strikes up or down depending on where the indices are trading at the time of entry.

I know I've probably left out some important details here, but I think we've got a pretty good roadmap to work with. Get your action plan laid out now and then wait for the fireworks to begin!

If I've left any questions unanswered, feel free to drop me an email and we'll address them in group fashion as time permits.



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