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August 27, 2008

Bear Eyes

Let me show you a very simple chart. It displays only a price series along with a moving average. Take a gander and let me know what your first instinct is for the near-term direction. Bullish or Bearish?

stock chart

My first thought was bearish. We see a sharp rally followed by a correction. However, rather than resuming an impulsive upswing at the end of the consolidation, price has crawled along the MA. Not a good sign. These crawls usually resolve with a break of the MA, meaning this price series could head much lower.

Of course, I suffer from a typically bearish bias, which is why we're conducting this experiment. If you haven't figured it out, the chart is the S&P 500 flipped vertically. So if one objectively believes the chart above is heading "lower," then one has to expect that we are on the cusp of a significant rally in the SPX. Such a rally would fit with the "one last curve" thesis I posted after Monday's drubbing. I expressed doubt that the drop was the start of a serious sell-off, primarily because there was no volume commitment. We are now back within 10 points of Monday's high.

As a caveat, keep in mind that the market is simply littered with head fakes of late. It seems the last week or so has been brutal to anyone trying to commit to a bullish or bearish stance. These periods are usually immediately followed by a significant move in one direction or the other. Perhaps simply buying volatility is more prudent than trying to guess that direction. As an experiment let's hypothetically buy two options, September expiry, and see where they land on options expiration.

Going 20-30 points in each direction, we can purchase the 1300 call for 14.25 and the 1250 put for 12.00 for a total cost of 26.25. We make money if the SPX finishes above 1326 or below 1224. In fact, I'll keep the status posted on the home page starting tonight.


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