What a day.
The DOW plunged 502 points on Tuesday, February 27, 2007, and recovered to close down by 416 points and change (3.3%) - it didn’t finish at the day’s low, though. The S&P 500 finished 3.5% down, the Nasdaq composite 3.9%. That’s the biggest one-day drop since 9-11. This selloff was provoked by a 9% selloff in the Shanghai market, which in fact led to a worldwide selloff. A lot of stocks fell today, most anywhere from 2% to 5.5% - to keep it in perspective, that’s about $1.50 on a $30 stock, not exactly panic city.
Interestingly, a number of stocks had an up day, among them Syneron, Marvell Technology Group, Mine Safety Appliances, RadioShack and Cogent. There were 29 stocks down for every 4 gainers, about a 7:1 ratio. (I’m famous for pointing out that there are good stocks that go up even in bear markets. To quote Joe Jackson - the musician, not Michael’s dad - “There goes your proof.”)
The DOW made a double bottom in June/July 2006 and has been on a huge bender since then, rising roughly 2,100 points without a meaningful pullback in 7 months. So we were due for a pullback; really overdue. Additionally, investors have ignored concerns about softening in the economy, although economists differ heatedly about whether a recession is on the way. I think the US market was already cocked and locked awaiting a correction and that the Shanghai selloff was really just the catalyst for it.
Whether this is a one-day correction or augurs a much larger market slide remains to be seen. Wednesday the 28th brings a revision to Q4-2006 GDP numbers, which are expected to be revised downward from 3.5% to 2% - this in connection with the recent softness in durable goods orders obviously would not help matters, nor the fact that corporate profits are beginning to falter after 18 months of stellar growth and that the US housing market is faltering.
Maybe this will be a bad week, nothing more. It is axiomatic that quick selloffs tend to recover with relative quickness. But corrections after extended trends frequently pull back (in bear markets, advance), or retrace their direction, to a point that is 38%, 50% or 62% of the amount of the uptrend (downtrend), according to Mr. Fibonacci. A 50% retracement would take the DOW to about 11,730, and a 38% retracement only to about 12,000, where there is some real support. A really big pullback of 62% would take the market to 11,500. Whether the pullback will reach any of those numbers remains to be seen.
I will be surprised if the 12,000 level is not tested this week (the market hit the 12,100 level Tuesday), but you never know. Actually, I would feel better if it is tested. Markets correct, and it is more worrisome when they don’t than when they do. If Tuesday’s pullback was a one-day wonder, I would worry more. As I write this, Asian markets seem to be selling off more, although it is too early in their trading day to say.
But enough prognosticating. How should a covered call writer react to this event? First, don’t put on any more covered call positions until the market direction sorts itself out. It could continue falling as it looks for those Fibonacci levels. Give it a few days, maybe a week, to allow for market head fakes and get some clarity. A real retracement could take awhile and the market could start trading at a lower level.
Don’t rush into any bear put or bear call trades, either, because if we don’t get a Fibonacci retracement the market could come roaring back - especially in view of the cause of today’s little crash.
Second, if you have covered call positions on, watch them and be ready to take action if it appears that a further market slide is occurring. You can buy OTM protective puts or roll the calls down (or down and out) for more downside protection. Remember, if you wait until the stock has dropped too much, it can get to the point where rolling down or even down and out does not help. Use the CallWriter Trade Management Calculator to check out the utility of potential rolls (it will look at two rolls at a time). There are other techniques I will teach at the upcoming intermediate-level seminar, but this blog doesn’t offer space to cover those points.
If this WAS a one-day correction, then it is back to business as usual.
So don’t panic, everyone. I won’t say today’s correction was fun, but it was needed. The rain in Spain can be a pain, but even when it is ill-timed and annoying, the rain can be a blessing. So, too, market corrections.
