Playing A Falling Market.
Today we talk about finding and playing another type of stocks in a falling market other than those that have spiked up in price. Actually, these plays are around whether the market is rising or falling. Indeed, over the past three years many bears have lamented that the gains in the averages were shared only by those stocks in the averages as the majority of stocks were not only not participating in the advances. In addition, stocks suffer bad news or a decline in earnings that can send them into a downtrend while the rest of the market trends up.
What we look for are stocks that are trending lower and are close to their 50 or 200 day moving averages or a support level. By support, we mean a point where the stock has spent time in the past. It can be previous tops. It can be a tight range where the stock has spent a lot of time. Think of it as rubbing a deeper groove in that price the longer a stock spends time at a particular price. When it gets back to that price, it will tend to fall in that groove, and it takes a strong move to get it out of the groove or to get it to pass the groove without stopping. When stocks break below these levels that is a sign that investors lack confidence to a degree that the stock falls out of that groove. These are critical levels, and if investors like a stock, they will often use these levels as a buy point. If a stock breaks below them, it is a sign that investors have lost confidence in the stock.
Just like stocks that we play to the upside on a breakout from a consolidation or base, we watch for stocks that are hugging support levels or resistance levels and then fall. The moves can be rapid as are breakouts. Just as when a stock breaks to the upside through resistance, we like a potential put play to break support or fall from resistance on rising volume. That means sellers are winning and driving the price down. Moreover, once a stock breaks below support it will continue to trend down just as strong stocks tend to trend. Moreover, downtrending stocks will continue to test their down trendline and fall back just as a rising stock will test support and then bounce up as buyers take the opportunity to snap up shares from the weaker holders.
When a stock breaks support it will often move right back up to test that support level as buyers try to push it back up. If a stock is going to fall, the test will ‘fail,’ i.e., the stock will touch close to the former support (which is now resistance) and fall. When if falls, that is the sign we are looking for. We can then enter put positions and ride the trend down. What we then do is start drawing trendlines connecting as many peaks as we can. That way we can determine if the stock is breaking its downtrend and decide if we want to exit the trade.
Again, these stocks are usually around in up trending markets just as there are stocks that are moving up in a down market. There is more interest in playing stocks to the upside versus to the downside-it is investor psychology to play the positive, and falling stocks are seen as negative. While we like a rising market as it makes investing easier, when things turn down, we have no problem playing stock to the downside as conditions warrant. You just have to stop thinking of falling stocks as a negative (as long as it does not last months) and more as another way to make money. You have to shift gears a bit and think backwards to a certain extent. This is another reason we are always watching for signs such as distribution days, broken trendlines, and the like when watching the markets. It allows us to be ready for change, not surprised by it. If you are not surprised, odds are you have a plan of attack, or at least know what to do other than just panic at the thought of your stock values dropping.
As we have been trying to convey over the past few months, it is not necessarily hard to make money in the markets, you just have to think a bit differently. Your emotions will kill you-emotion is what drives the market and if you are playing emotionally, you are playing right into a trap. When stocks reverse, it is not time to panic, but time to capitalize on those strategies that work in a falling market: selling stock to lock in profit, selling covered calls on long term holds, buying puts to capitalize on the fall, selling naked calls (i.e., without owning the stock), creating bear spreads. You have different tools to make money in the market. When market conditions call for the use of bearish tools, that is what we use.
Last night we talked about playing leaders that had a lot of fluff built in them after a strong rally and the market became choppy. Today the market was up out of the gates, but started to sell off. Many of the leaders off, including several we had highlighted: EXDS, SFE, VRSN. They then turned back up and rallied with a vengeance. Fast in, fast out. This was faster than we even thought. When selling really comes in, we usually get a couple of days, or a day and a half. As we said above, this rally does not want to die. There will come a day sooner than later that we will get selling all over again, and it will last longer. Keep building a list of the really high fliers that have put options available. Some huge gains can be made when the selling starts. Some good gains were made today, but you had to be on top of the situation. This weekend we will discuss finding put plays in everyday trading. They are out there all over the place. The can be very steady money makers when you get in at the right time. Sounds familiar doesn’t it? Timing is everything.
