UPDATE: I misspoke in the original post. The stock market is OPEN on Monday, October 13th.

Ye gods, what a couple of weeks! Starting on October 2nd, the market has been driven by sheer panic. The retracement has been over 40% from the October 2007 market high. If you recently put on covered call positions - using good stocks - without using the SuperPut structure, I sincerely hope you have not taken needless panic losses. Pretty much all the individuals in panic mode have sold, and we are starting to see a climax in institutional (hedge funds, etc.) selling.

This has indeed been a panic-driven selloff. The situation was never quite as dire as the administration painted it, but panic is self-sustaining. Pros sell at the top, buy at the bottom; amateurs do the opposite. So why have institutions - which have driven the panic - been selling out? Money managers will not be put in the position of explaining why everyone else got out and they didn’t. Many institutions saw the writing on the wall and got out, intending to get back in at a bottom. Indeed, many automated programs will start buying at about the 8,000 level on the INDU.

Unless you have lost all faith in the American economy and think it’s headed for the trash heap, it has all along been a matter of where the market ultimately finds support and rebounds. For this to happen, the selling must climax, which is likely, though not certain, to occur at a historical support level. Thus the bottom is unknown, as is the strength and momentum of a rebound. But we can look at some obvious support levels for the Dow Jones Industrials (INDU):

10,700 (2006) - blown
9.800 (2004) - blown
9,000 (2002) - blown
8,000 (2003) - being tested
7,500 (2003) - not in play yet
7,197 (2002) - not in play yet

The market is testing the 200-month moving average as the chart below shows:

As you can see, volume is headed towards a climax and capitulation point. This does not mean a bounce is right around the corner, since the market could easily look for the lower support levels. Much will depend on how much automated buying kicks in, and when. A decisive break below the 200-month moving average would indicate that the we’re going to test lower levels yet.

Volatility Indices
The CBOE volatility indices, which function as sentiment indicators and move inversely to the market (they’re high when the market is low) have all hit all-time highs; in fact, they keep reaching new highs:

$VIX - hit 74.46 today (previous high 49.53 - 1998)
$VXO (OEX volatility) - hit 99.65 today (previous high 72.13 - 1997)
$VXN (Nasdaq volatility) - hit 80.37 today (previous high 71.72 - 2001)

I’ve had to revise those highs skyward - twice - since I began writing this post. Those are 7, 10 and 11-year highs, at least based on the “official” indices. Note that the current VIX (tied to the S&P 500) was newly created in 2003. The “original” VIX was launched in 1993 (tied to the S&P 100), but was re-christened the VXO in 2003. Because it is older and S&P 100-based, and perhaps because VXO options are American-style, many market commentators prefer the VXO (old VIX).

NOTE: VXO (old VIX) data actually goes back to 1986, before launch. Using those numbers, the VXO would have hit a high of 152.48 on October 19, 1987 (Black Monday) and a high of 172.79 the following day. Source: VixandMore

Wrap-Up
The market will in all likelihood soon find a bottom and begin to recover. However, it may well be an intermediate bottom, with lower lows to come. In other words, are we going straight to THE bottom now, with a stronger recovery, or will we see only an intermediate bottom, with the market continuing the falling-range behaviour we saw from October 2007 through September 2008?

If the market does bottom soon, don’t assume the market gyrations and volatility are “over.” They likely won’t be. At the very least we will continue to see a lot of choppiness and volatility.

How strongly will the market snapback? Unknown, but programmatic buying will move the market smartly once the selling climaxes.

Covered call writers:
Use the SuperPut structure when you start writing again. Those long puts have a life of 6-8 months, and the likelihood of the market coming back down in that time frame is, um, reasonable. So don’t think you are throwing away the put cost.

On stocks that are down, do not write below your cost basis, or you will be forced to close those calls at a loss on a market snapback - and the magnitude of the snapback could be ferocious.

This entry was posted on Friday, October 10th, 2008 at 12:31 pm and is filed under Covered Calls, Markets/Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.