Home In on Those Technicals

 | Aug 17, 2014 | 10:30 AM EDT  | Comments
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One of the things option and stock traders struggle with is the mental part of the game. Nobody who trades each day remains unaffected by the emotions on display in the markets. Price action and volume represent a sea of emotions -- which are plainly seen on a chart. We can clearly see moments of fear and greed via the green and red bars (buys and sells). The parameters do not change, either. Think of it as a football field, with fear on one side and greed on the other. We are all trying to move up and down the field with a minimal amount of emotion, but we are often pulled to one end or the other for various reasons.

Amid all this, in order to be successful we must overcome the need to be completely informed. Much of what the market presents us to us, of course, is uncertainty. Nobody can tell the future with full accuracy, and the chart is a perennial mystery. We are constantly looking for clues and listening to anyone we deem smarter than ourselves who might make our job a bit easier.

Do we listen when Carl Icahn says a big correction is coming? We already know that will happen someday, but do we act when he says it? Does it make sense to follow a person such as David Tepper or George Soros? They may well say, "Do not be too long now" -- and then, a month later, "I didn't really mean that."

When I'm trading options, I pay little attention to all that. Instead, I study the charts and listen to the market, as these will guide me to better results. While news is important to understand and digest, we must always put it in context and determine its relevance. Here's what's more important: How is the market reacting to the news?

Take the first week of August, for example. The S&P 500 had been pasted about 40 handles lower on huge volume -- and, after Aug. 7, some news dropped futures overnight another 10 to 13 points. It had appeared the S&P 500 would open under 1900 for the first time since it had first crossed that level in late May.

But, alas, the markets were vastly oversold at that point. Sentiment was as bearish as could be, the CBOE Volatility Index (VIX) had risen nearly 40% in a week and put-call ratios clocked in with more than a 1 reading for a few days. As for sentiment, markets had been battered the prior few sessions -- so, if you had been long stocks or call options, you had started questioning yourself. After all, if this is the "end," why would you want to be left holding the bag?

Basically, these conditions could not have lasted for too long -- the rubber band had been stretched back too far. As a contrarian looking at trends, I saw that the odds favored a swift and strong turn. At that point, markets had been falling on both bad and good news -- yet, with the markets so oversold, that overnight news had a negligible effect on Aug. 8, and the indices rallied sharply. Coincidentally, this occurred off the 100-day moving average, which has been a great spot to buy modest 3%-to-4% pullbacks so far this year. See the chart below.

S&P 500 -- Daily
Source: StockCharts.com

Here's my point: The news was important, but understanding the market conditions was more important. You may well have thought this market would fall apart -- everyone on CNBC seemed to think in this way -- yet you would have been badly burned if you had played the downside last week. How would this have affected your mindset? I believe it would have done your head in.

So, as always, I suggest paying attention to the message of the markets. Be open-minded to the technical conditions you see, and allow yourself a chance to be successful. As I often say, trading is not a game of perfect. But prepare yourself and your mind for battle, and you can more frequently be on the winning side.

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