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Trader's Corner

Bottomless?

HAVING TROUBLE PRINTING?
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OIN SUBSCRIBER QUESTION:
"You discussed in your weekend comments some conditions or things that should occur before you would expect to see a bottom even a temporary one. where do you think we are now given the further 1700 point drop?"

RESPONSE:
Yeah, as of today, Thursday, the Dow is down another 1746 points on the week. Like the portfolio managers of the world I tend to look more at the S&P 500 (SPX) and there, hard to believe, SPX has fallen another 189 points!

Here's the key things I wrote about on Saturday in my Index Trader Column that I thought would occur before even an interim bottom would be seen. Some of what I wrote on Sat:

"In terms of charts and indicators, there are some things that I would anticipate as to how and where a next bottom might form:

** Almost certainly, trader sentiment is going to get MORE bearish than it is now in terms of call to put readings; i.e., as a ratio of total daily equities call volume in relation to total daily put volume.
** ...shorter-term daily oversold indicators like RSI are going to get 'fully' oversold, just like the weekly ones are now, before there's a bottom worth trading, either to sell index puts or buy calls for an intermediate (e.g., 2-3 week) rebound."

I also suggested that we should look next for 'support' at the '05 and '04 lows...NOPE!! How about the 2002 lows instead!! I'm reminded forcefully that, in a 'waterfall' decline like this (a major PANIC like hasn't been seen in decades), prior lows and possible support are being knifed through, so I rely more on what certain key INDICATORS (RSI and 'sentiment') say about the conditions that might signal the major indexes were ripe for a turnaround; one key condition was met only TODAY.

I'll discuss the aforementioned TECHNICAL factors, but first would note TWO other FUNDAMENTAL market influences that may be in play here that you may or may not be aware of.

1.) As I noted on the weekend, short-selling restrictions for 700+ financial stocks were REMOVED as of the close yesterday (Wed), so some renewed shorting may have occurred today in those stocks.

The stock market is reacting more than anything to the frozen and seized up Credit Markets.

LEHMAN AND A MAJOR CREDIT MARKET OVERHANG:

2.) Lehman Brothers (LEH) was heavily involved in the derivatives market and selling credit default swaps. Unlike the other big investment banks, Lehman was allowed to fail and went into bankruptcy. The credit market started going over a cliff from that point on. A major reason for that is that parties on the other side of LEH transactions could hope that the firm would make good on the 'insurance' implied by all their credit default swaps and other derivative trades. This brings me to an impending event that, if we get past it, could help lift the extreme selling pressures.

Some $400 billion in Lehman credit derivatives The Lehman Brothers (LEH) credit derivatives are due to be settled tomorrow (Friday) and this has been a factor in scaring away would be buyers of stocks. Significant fear can be tied to the major losses coming from this derivative unwind, with JP Morgan Chase (JPM) having the most exposure to such loses.

Participants with LEH in these derivative traders can ONLY offset these contracts; they can't 'settle' them. These participants no longer have a COUNTERPARTY to their trades with Lehman, due to its bankruptcy. This has put pressure on some of the parties to these trades to buy more credit insurance and the cost of these, just like short-term loan rates, have been RISING.

Banks are hoarding cash in the expectation of payouts on up to $400 billion of defaulted credit derivatives linked to Lehman. The Fed is helping set up some counter-measures; e.g., creation of a central counterparty for credit default swaps by the end of the year.

Meanwhile tomorrow, Friday, is D-day and there will actions going on in the morning related to the debt backing for these expiring swap agreements. The progress and outcome of what is going to be a big Swaps auction market tomorrow morning, winding up around 2 pm (EST), MAY help calm the market and bring in some buying, especially short-covering.

TECHNICAL CONDITIONS 'SIGNALING' A POSSIBLE BOTTOM

I mentioned needing to go back now to the 2001 lows to see where next 'support' might come into play. However, in this type major panic, some event(s) or news can come along at any point and rally the market, so I'm not necessarily looking for buying to only develop in the S&P 500 when and if the index gets back to the 800-826 area, especially given how oversold SPX is in terms of its long-term RSI indicator as noted in the yellow circle. Keep in mind that the final reading for this week in the 13-week RSI will be reflected in the CLOSE tomorrow in the index.

A projection out into the future of the current or past rate-of-change in prices (i.e., a trajectory of price 'momentum') is what a trendline is. As of today, SPX has even fallen under its prior most negative prior rate of downward momentum, which was seen in June-July. This is represented by SPX today having pierced the downward red (dashed) trendline. This move has finally put the 13-DAY RSI into a 'fully' oversold conditions which is one of indicator events that I thought would occur BEFORE a bottom was seen, even if only an interim one.

The other key INDICATOR event that I was convinced that would occur at or near a bottom was a decline in my sentiment indicator (the 'CPRATIO' line) to a level reflecting 'extreme' bearishness for AT LEAST one day, if not also on a 5-day moving average basis. The dynamics and psychology of market bottoms is that they tend NEVER to occur UNTIL after there is an EXTREME in bearishness. NOT seeing such an extreme is a good 'signal' to stay short or long puts.

Until today this LACK of extreme bearishness among option traders was the case. However, based on equities put volume today finally outpacing total call volume on the CBOE as reflected in my sentiment indicator below, this alone suggests the conditions will set up for a rebound relatively soon; e.g., within 1 to 5 trading days.

The same conditions regarding how oversold the market is and the extreme downside and accelerating momentum is seen also in the daily Nasdaq Composite (COMP) chart below.

GOOD TRADING SUCCESS!

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.
 

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