Next Week Could be Very Interesting

Mar 16, 2008: 10:13 AM CST

Why? Because the Federal Reserve meets on Tuesday to announce a new interest rate cut of up to .50 or .75 bps, which could be a major market mover up or down, and quadruple witching expiration occurs this Thursday. While options expiration normally takes place the 3rd Friday of a month, this Friday, March 21st happens to be “Good Friday,” and the markets will be closed, and although the expiration will take place as usual, the last day to unwind these positions will actually be Thursday, which will likely result in larger than normal volume and volatility.

It makes conservative traders want to hide under rocks and aggressive traders want to jump into the almost certainly volatile action that’s ahead for us.

If you’re unaware of the results that a Fed cut announcement has on the market (flat day until the announcement, then a large, often sudden ‘three push’ move one way or the other than can be 200 or more Dow points in less than 30 minutes), and what happens during a quadruple witching expiration, I recommend trading reduced position sizes next week due to the possibility of heightened and unpredictable price swings potentially in both directions. You may want to confine yourself most days to the intraday time frame unless you have gathered experience trading weeks like we’re about to have.

According to the Street Authority website, a quadruple witching occurs when, “index futures, market index options, stock options, and stock futures all expire on the same day.” Furthermore, “On quadruple witching days, many investors attempt to unwind their positions in their futures and options contracts before the contracts expire. This activity frequently includes repurchasing contracts and closing out other positions meant to hedge against these contracts.” In other words, erratic price moves occur which defy both fundamental and technical analysis.

What’s likely to happen? “Quadruple witching days are usually accompanied by considerable volatility in stock and derivative prices, as well as increased trading volume. As a result, investors can anticipate and plan for the potential effects of these relatively turbulent trading days.”

Don’t let this week catch you off guard. If you’ve been doing well, the market environment might possibly throw you a curve ball next week and degrade any edge you have temporarily.

UPDATE: In an extremely rare weekend move, the Federal Reserve cut the short-term discount rate from 3.50% down to 3.25%, cutting rates early by .25 bps.

UPDATE #2: JP Morgan Chase announced late Sunday evening that they would be buying financial company Bear Stearns for … $2 per share. The $236 million deal represents a stellar collapse for a large US Financial lending institution, and raises concerns about what may be ahead. This deal was announced before markets opened, so as to contain the potential shock.

I couldn’t help but pass along this quote from the Trader’s Narrative:

“I have a nagging feeling this week will be one to remember. Whether it will be the bulls or the bears that will look on it fondly, only time knows.”

Know what’s ahead and then make the decision in advance how you’re planning to alter course as a result of the potential for large, unpredictable price swings on two or more trading days next week.

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This is Getting Serious

Mar 15, 2008: 6:00 PM CST

The US Dollar Index continues to make new lifetime lows, which is affecting other markets and economic environments.

The Index compares how the US Dollar fares against other currencies, and a country’s currency often is indicative of the economic strength. Rather than discuss complex economic factors, let’s simply look at the charts, which tells the whole story.

I’ve given you a bonus and added two key divergences which preceded price action both to the upside and the downside.

The monthly chart shows that the US Dollar Index peaked at $120 in 2001 and has now stands in 2008 at $71.67. As if this decline wasn’t serious before, it’s serious now.

With the Federal Reserve likely to cut interest rates next week, this will put further downside pressure on the index, provided the cut is not already factored into the price. Economic changes take time to filter through the price, but it’s clear the direction of the trend is still down and will take quite a large shift to turn the tide of this trend.

Also, it’s important to note that crude oil is priced in dollars for all countries, and so as the dollar gets cheaper, countries producing oil receive less profits, and so they do what they can to ensure that the price of oil rises to compensate for this discrepancy. Some analysts have said that it isn’t long before these countries move to quote the price of a barrel of oil in Euros, and no longer the dollar, which could help them. The Euro is currently stronger than the dollar, and the exchange rate is currently above $1.50 for one Euro.

As a bonus, let’s look at the price of oil since 1999, which was trading around $15 at that time and now trades at all-time highs of near $110.

For traders, these trends offer wonderful and stable methods to profit, but for average Americans and global citizens, these trends do not serve them in everyday life. Higher oil prices hurt all sorts of industries and individuals, and Americans are finding it more expensive to travel overseas. Multi-national companies based in the US fare well when they convert currencies from other countries back into US Dollars, but there aren’t a lot of other entities that benefit directly from a low dollar.

Nevertheless, these trends will be in force until a major economic factor (or cascade of factors) changes, but it’s probably best not to bet on that happening any time soon.

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Idealized Trades for Friday March 14

Mar 15, 2008: 10:26 AM CST

While Friday’s action was quite volatile, there were actually some very profitable and simple trades you could have taken within the price structure on the day.

Let’s look at the DIA (Dow Jones ETF):

The day did not begin with a significant gap, yet within the first 30 minutes, price had fallen from $122 to beneath $119, which was a 300 point Dow drop. It was difficult to get any entries into this large volatility momentum move down, which occurred due to fears that the recent economic (financial) injection (stimulus plan) might not work after all to save the banks from financial crisis. Shortly afterwards, the Fed announced a major bailout of Bear Stearns (BSC), which was the major new event of the day.

Price recovered, and found significant resistance at the falling 20 period MA, which set up a short-sell trade if you were aggressive (trade highlighted in purple). Price inflected off the daily S1 pivot (not shown) and then pulled back to the falling 20 period MA again, setting up an identical trade which terminated also at the daily S1.

Savvy traders may have noticed a triangle consolidation forming, which prompted them to stay out of the market until a break of consolidation occurred. Even though the day had so much negativity and downside momentum, it’s still best to wait until price breaks because you cannot predict the actual price ejection direction from consolidation triangles (though triangles tend to be continuation patterns).

The break on higher (relative) volume signaled a trade to the downside, which targeted the distance of the height of the triangle, which witnessed a disheartening ‘throwback’ (notice the doji candle just before 1:00) which took out conservative traders with tight stops in this short-sell trade.

The initial break paused and formed a 45 degree angle pull-back into key resistance again by the 20 period moving average, which set up a high-probability short-sell trade again which was a classic bear flag (which achieved its target perfectly, which happened to be the intraday low).

A lengthy momentum divergence had been setting up all day as price continued to make lower lows, signaling that a turnaround was increasingly likely. Indeed, this occurred, as the day closed with moderate strength, rather than closing on its lows.

An “impulse buy” trade set-up with momentum making a new high and the pullback into moving average support allowed for a buy-side (long) trade with a small target (which gave you 50 Dow points into the close if you are a pure day-trader).

While there were many more trades to be located, I always recommend you keep a file or journal of what you perceive to be the ‘ideal’ trades of the day, and then look at your results to see how much of those ideal trades you captured, or what percentage of the available profits (or losses) you achieved from these trades.

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A Peek at Gold, Oil, and the Dollar

Mar 14, 2008: 9:15 AM CST

Without getting too deep in explanation, let’s look at the technical picture of Gold, Oil, and the US Dollar Index on the daily charts:

First, the plunging US Dollar Index:

On to Light Crude Oil (one barrel):

Finally, Gold Contract Prices (one ounce):

Finally, let’s compare the relative performance of these markets (from 180 days ago until today):

There is a classic inverse relationship between the US Dollar Index and (most) commodities.

Recall that gold is a protection against inflation, and oil is quoted in US Dollars, so that when the dollar weakens, oil prices are inflated.

Notice also the almost mirror image of the US Dollar and the Crude Oil chart, down to the divergences and consolidation rectangle pattern. It’s quite amazing.

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ALERT: Bear Stearns Plunges 50% Today

Mar 14, 2008: 9:12 AM CST

Bear Stearns (BSC), one of the major US Financial companies, lost half its value intraday today on concerns that the Fed’s recent liquidity injection “might not work” for the company.

Instantly, the Federal Reserve voted unanimously today to provide cash to help this crisis, and stands ready to inject more as needed.

As reported by Yahoo News, the Federal Reserve issued a two-sentence statement, part of which said, “The Federal Reserve is monitoring market developments closely and will continue to provide liquidity as necessary to promote the orderly functioning of the financial system.”

According to Yahoo, “The plan will provide secured funding to Bear Stearns for an initial period of 28 days, seeking to provide short-term relief for Bear Stearns.”

Furthermore, “The action by the Fed board in Washington represented an endorsement of a rescue effort for Bear Stearns that had already been arranged by JPMorgan and the Federal Reserve’s New York regional bank, [which was] seen as a last-ditch effort to save the investment bank, which on Friday acknowledged its serious financial problems after a week of denials.”

With that news, let’s look at what happened to the stock prior to the news (or let’s see what caused this announcement to happen so quickly):

On to the massive decline in the weekly chart:

Before you start thinking this is a normal decline, realize how large Bear Stearns is to the US Financial markets, and what this might mean for the broader sector.

This is an extremely important development, which shows that investors must always be on guard for catastrophic events (news/fundamentals) in their chosen investment, and also highlights that even long-term investors should use some sort of position liquidation plan (such as an 8% or 10% arbitrary stop-loss, or some other risk control management plan).

At any moment, the unthinkable can happen in the market.

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