"They say that there are two sides to everything. But there is only one side to the stock market; it is not the bull side or the bear side, but the right side. "
Reminiscences of a Stock Operator - By Edwin Lefevre
Savvy investors know that it is impossible to consistently predict the direction of the market. There are simply too many variables to factor in. Still, to trade confidently, it's important to know as much as you can about what is causing the market's move in any direction.
There are important market indicators that can give you a feel for the shelf life of a market rally or sell-off. For example, you may have recently read a very important report that could have a major impact on your stock portfolio. The NYSE reported that "short Interest" (the level of shares of stock sold short which have not yet been repurchased) rose to record levels for the month period ending August 15th.
First of all, it's wise to at least take note that whenever we see record levels of anything, it is significant. But what does this mean to your liquid net worth? First, a very quick reminder of what this means in general. When a trader sells a stock short, he or she is essentially betting that the stock is going to trade lower.
Technically, what happens is that the trader "borrows" the stock and sell it, with the objective of buying it back at a lower price in the future. The investor profits on the difference between the "short" price and the "buyback" price.
When short interest is high, it means that there is a large number of shares that are still "short" which will eventually have to be repurchased. The fact that short interest at the NYSE is at a record level tells us that the market is extremely bearish.
It is important, however, to recognize that savvy investors see this as a contrarian indicator (at least for the short term. ) The contrarian argues that when the stock market sentiment is excessive, whether bearish or bullish, the market is most likely to change it's current direction.
Here's the key:
When there is a record amount of stock that is sold short, whether it be an individual stock or an entire index, the record share amount is eventually repurchased. The rapid repurchasing of all of that stock can cause a "short squeeze" resulting in a short term market rally. The result would be the opposite of the effect that panic selling has on stock prices.
In short, the market could rise dramatically. A short squeeze is likely to be nothing more than a head fake. Remember: One signal of a near-term bottom is when most investors including financial professionals talk as if they think that the world is coming to an end, and the market will never stop selling off - just like the sentiment that we heard in February and March of 2003.
The difference today is that we have rallied well above the 2003 turning point in the market. We have even hit four-year highs for most of the major indices. Once again, betting on the direction of the market in general is not a safe bet. It is, however, important that you are aware of these indicators and know why the market may be moving higher.
So what should you do?
1. Sell Covered Calls on Select Stocks: Don't get caught in a bear trap. Given several indicators that are historically right more often than not, if I see a spike in the market, I would either be selling covered calls on my positions, or reducing my exposure to the market by selling into any market rally.
If you can't decide what to sell, it usually pays to sell the under-performing stocks first, because they are the ones that usually have the hardest time recovering.
What hurts even more than sitting out during a rally is being the last one standing in the musical chairs market.
2. Keep Your Eye on the VIX: Another indicator of fear or complacency is the CBOE Volatility Index commonly known as the VIX.
The VIX measures volatility in S&P 100 options. It is a good tool commonly used for measuring investor fear.
If the VIX is over 40, you can assume that there is a significant amount of fear. When the VIX has approached 50, it has had marked market bottoms. Low readings (usually under 20), although considered to be less accurate than high readings, indicate significant comfort or complacency and have been known to point to market tops.
Yesterday the VIX ended the day at 13. 34. The high in mid-April was 18. 59, and the low was just set in mid-July at 9. 88.
If you are a trader, then you know that the trend is your friend. That is because traders have the agility to move quickly and adjust their portfolio accordingly in order to keep up with the market's (short-term) trend.
But you will be taking significant risk if you buy into these potential near-term rallies that may occur.
Earnings season is, for the most part, over. More than 95% of the S&P 500 has reported quarterly results. The market looks sloppy as there is no real sector leadership. We are seeing lots of mixed opens only to retrace recent lows.
3. Don't Forget to Keep Your Wits About You for the Fall: Traders are coming back from summer vacation to play, so keep your eye on the ball. These are dangerous times and could be the quiet before the storm. Don't be complacent when everyone else seems to be.
That's all for today folks. . .
Chief Investment Officer
Technical Analysis Millionaire