As I (and others) predicted yesterday, the market sold off today. The DOW closed at 12,099 on Friday. On a weak open today, it swiftly sold off 460 points to 11,634 and is fighting to hold on to the 12,000 level. There were a huge number of sell orders from around the globe this morning, so the market was bushwhacked.

I remain short-term bullish; short-term only. The market should recover some of the lost ground, but this will only be a bear rally. The medium- and longer-term prognosis is not good. Don’t depend on the election year to save the market. I am not counting on the market to recover today, but it may begin a short-term recovery this week.

Some thoughts for covered call positions:

A lot of covered writers are in impaired positions. However, if you write covered calls on a market rebound, you will be caught in the assignment trap - forced to be called out at a loss or repurchase the short calls as the stock rises. It is usually better in this case to simply let the stock recover. If you are short calls at a strike below your cost basis, consider closing the calls and letting the stocks recover with the market.

When a stock recovers enough, consider taking profits on covered call positions or turning them into SuperPuts by purchasing the long-term puts, where the puts are cheap, with very little time value. It is advantageous to construct the SuperPut at a higher level. By example, if a stock ranges from $100 to $110, it would cost a lot to buy the 110P when the stock is $100 - we would pay $10 in intrinsic value, plus time value. But when the stock rises to 110, this is the time to buy the 110P, which offers far more protection.

Implied volatility being about the same, it will cost about the same to buy the 110P when the stock is $110 as to buy the 100P when the stock is $100. So it makes more sense to add the long put at the higher stock price. This is why I am more inclined to establish the SuperPut at highs, at range tops.

On the other hand, puts get pretty expensive when a stock is falling. We pay too much time value then due to high implied volatility. And when the stock stabilizes, the IV evaporates, diminishing the put’s value. A big key to the SuperPut strategy is not overpaying for puts.

If the puts are expensive (more than 2% monthly), it might be better to find another stock. As the stocks fall again with the market - and they will - the long puts will make it possible to write calls on the stocks (and close and trade the calls to generate additional credits) with impunity, since the long put provides a price guarantee.

I look forward to a brief market recovery and to establishing all SuperPuts at the higher price levels. Don’t be discouraged or freaked out by the market volatility. We are about to be in a terrific position to place SuperPut trades and laugh at further market decline, because the long put will make falling stocks someone else’s problem.

Today (Martin Luther King Day) the US stock markets were closed, but the US futures market was open, as were foreign markets. The picture is fairly grim. Foreign markets are down 4% (Canada) to 7% (Paris). Stocks in Europe are now down more than 20% below 2007 highs, which meets technical definitions of a move into a bear market there. The pan-European Dow Jones Stoxx 600 index slid 5.4% on losses from Societe Generale, Allianz and other banks and insurance funds.

The global sell-off has been blamed on lukewarm reaction to President Bush’s stimulus plan announced last week, but the world’s markets have been cocked and primed for this as the credit crunch worsens and the extent of the subprime problem becomes clearer. Negative comments about subprime from a French banking official sent the Paris market down the most of all. They are now trying to erase his remarks, but the damage was done. This was Europe’s worst sell-off day since 9-11.

US futures were sharply down today, as well. Futures were down on the DJIA (520 points), S&P 500 (60 points) and Nasdaq (76 points). Whenever futures are down before the stock market opens, it usually heralds a down market day. Unless futures spike up tomorrow morning (and perhaps even if they do), there is a real likelihood of a further fall in the stock market.

For those who read the tea leaves, this is not good news. Major publications are using the “R” word pretty freely now, along with terms like “global free fall” and “global train wreck.” I don’t know if it’s as bad as all that, but it ain’t good. Things are going to get worse, much worse.

Let’s look at some charts:

The DOW closed at 12,099 on Friday, which is almost 15% below its 2007 high of 14,198 and well below August’s correction low of 12,517. We have a long way to go to reach the 20% mark off the 2007 high (11,358), which would be a technical signal we are in a bear market. The bear is, I have noted on prior occasions, snuffling his way our way. It’s only a matter of time. Is the time now? Maybe, but my money is on a snapback in the market and continuing the rolling pattern it has been in - if we don’t break sharply lower. In the chart below, note how the DOW has broken below its recent trading range, with two closes below the bottom trendline:

The sell off in recent weeks has occurred on increasing volume. The DOW is now testing the low of the Feb-March correction from 2007. Just doodling on the chart, below, I am wondering if we have not possibly seen a head-and-shoulders top to the market?

It looks kind of like a H&S, and the neckline falls rather classically, does it not? If the top was a head-and-shoulders formation, then the market has broken decisively below the neckline. Needless to say, a break (several closes) below the Feb-March correction low will be trouble. I think the old bull still has some legs left. At some point, traders and investors will decide that the market has sold off enough (for now) and buying will come roaring back in. The problem is, the big institutional players actually read and digest the financial news and its economic implications and are bearish. But the problem with going to cash is that so many places we would put our cash also are beset with subprime and similar problems in their asset mix. Hmmm, want to put your money in a bank? Better pick the right one…

What to do?

First, be watching the futures before the stock market open tomorrow, which MarketWatch.com usually covers. Although I rarely trade in the first 30 minutes of the day, be thinking about buying puts to cover long stock. I would consider buying ATM or near-the-money FEB puts on unprotected positions. If the market does not sell off or the sell-off is short lived, close the puts. A short-term bullish sign would be for the DOW to break higher back into (close in) the range it has been making. Even at 9-11, the market didn’t keep plunging, and it won’t this time, either. I will only buy puts tomorrow for the opportunity to profit on them if the market seems to be selling off again, because I expect the market to snap back.

Second, your future covered call writes should be SuperPut-protected. Those who wrote at higher price levels using the SuperPut strategy are not concerned with the market sell-off. Bluntly, it ain’t their problem. This is the way you should be trading. Limit your losses to a few percent of the trade debit, and soon make the trade completely riskless. This is the way to write covered calls, and you can do it all through the worst bear market. In fact, the dropping stock becomes your friend.

I’ll be giving out more information soon about my SuperPut strategy and our new SuperPut lists, so keep watching. A bear market is to be feared only by those who aren’t protecting their stocks properly.

Yesterday (1/3) I put on some trades, since I like to write on market down days. I didn’t know today would be another market sell-off day, but who did? I want to do more this year of sharing my trades and thought processes with you. I won’t always be right, any more than you, but my goal is profit, not glory. I want to discuss one trade in particular: Amazon.com (AMZN):

I’ve done well with AMZN - it has been berry, berry good to me. The more I think about etailers, though (and AMZN is the big dog in etailing), the industry is a bit overbought, with a P/E over 100. So when the stock dipped today with the market sell-off, I decided to roll the calls down and out. I bought back the JAN 95C (-1.97) and sold the FEB 90 Call (+8.15). This lowered my cost basis to $86.02 in a stock that cost $97.00. Thus if called on the FEB 90C, I make roughly $4.00 a share, or 4.3%.

FEB expiration is on 2/16, which is 42 days out. If called, my return will be 3.1% normed to a month [4.3% / 42 days x 30-day month). This means that absent further selling off I will make a return that is at least 3% per month. I’m doing several contracts, so trade costs are minimal.

Should I have rolled down? Well, AMZN has started to come back a bit, but who knows? If there is bad news, I will be happy for rolling down-and-out. If it snaps back, I will not cry about leaving money on the table. 3% a month is not bad where I come from, and I’ll take it happily.