Cognoscenti?

Less than an hour before the close Phil commented “Wow, ending the day with another nasty sell-off would suck!” Well it did suck! In that hour the NASDAQ dropped 30 points, down 43 points for the day and the Dow dropped approximately 100 points.

It seems an age long long ago when we saw Google fail to hold its support level (just 5 days ago) Indeed it broke its 5-day EMA that held as strong support on the rise from its breakout at $527 to its peak around $740.

The carnage has been all-encompassing. In just 5 days the momentum names have dropped significantly.

GOOGLE: From $740 to $632

APPLE: From $190 to $153

RESEARCH IN MOTION: From $135 to $102

And on and on….

After hours Google is down another $5.07, Apple down another $1.41, Research in Motion down another $2.15. The result of the carnage is panic IS starting to spread among the cognoscenti. Some of the comments from the numerous articles in the financial community include:

“A market implosion is rare, but years of risk and denial, helped along by the Fed’s recklessness, have made a wipeout far more likely” Bill Fleckenstein

“…the stage has been set by the reckless policies pursued by the Greenspan Fed in the past decade and a half. These have enabled the risks to pile up while rewarding folks for ignoring them. The Fed’s efforts to stave off small forest fires have guaranteed a gigantic one” – Bill Fleckenstein

“This market is AS bloated and in some ways MORE than it was in 1999 and 2000. That’s basically a 2% drop. That’s relatively small in the grand scheme of things. There is no question in my mind that we will have a 1000+ point drop on the DOW in a single day. I would say that the Nasdaq will drop at least 150 – 200 points on the same day, with an outside shot of a 250 point decline potentially” – Michael Parness

“Recession is a normal part of the business cycle. It can’t be avoided. The economy needs to unwind so debts can get written off and businesses can retool for the future. The upcoming recession is shaping up to be worse than its predecessors—a real doozey. The damage caused by the Fed’s excessive credit has been considerable. It’ll take years to mop up the red ink and set the house aright. The markets are in a shambles, investors have been battered and confidence is gone.” Mike Whitney

Further concerns include, the unwinding of the yen carry trade putting pressure on commodity stocks, the Fed pouring money into the monetary system to soften the damage, rising U.S. debt, oil at record levels and when you think it can’t get worse the old problems of social security and medicare raise their ugly heads! And I am seeing more books pop up on the economic future of America including Robert Kuttner’s “The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity”

We have been and continue to encourage the utmost caution.

On November 8^th we commented to our members “We would not consider this market very healthy…..that means more hedging (required) commensurate with risk tolerance…..we need to remain ever-cognizant of the power of sentiment. When fear incites panic, don’t fight the crowd. It’s time to hedge and stay safe.”

On November 9^th we cautioned of the dangers of greedy trading by way of a comparative example: “.. for those of you in the United States that can watch the show “Deal or No Deal”, note how the same people who start a show claiming that $100,000 would get them out of debt, help put their child through college and pay off the credit cards are the same people who reject $140,000 when a chance to make $500,000 is on offer. Yet when they blow that chance at $500,000 and are left with the prospect of making a maximum of say $20,000 they are so annoyed with themselves that their decisions become purely emotional and sometimes they walk away with nothing! “

In the same article we commented on how to lock in a position, hedge heavily and stay safe while riding through the storm. The example was a Google collar trade, where we locked in gains by applying long puts and short calls at the same strike price, 690.

This pain felt by most traders is palpable now. Panic IS starting to set in: The VIX is above 30 again – a level it breached during the August collapse. BUT we have not seen capitulation yet. When we slide to the lowest levels of the day in the last half hour, the likelihood is that there is more to come.

The market almost always goes much further than you ever imagine. Don’t expect the bottom to be found too quickly and don’t be surprised to see a bullish trend continue long after you believe a company is overvalued. Sentiment is POWERFUL.

To signal a bottom we are looking for a sharp reversal AFTER panic has set in. Just take a look at the August bottom intra-day. While we may not see the exact same occurrence, we should be on the lookout for this to signal the end of the decline.

We have mentioned numerous times over the past month how the collar trade is the foundation of our trading approach. If you are suffering wild swings in your virtual portfolio that exceed your comfort levels consider the collar trade. It’s hard to go too far wrong. You define the risk and reward when you enter the trade.

For example, if I was holding a momentum stock but was concerned about a continued decline while still hoping to squeeze out a nice gain over time in the event the stock rose higher, I could apply the following position (let’s use RIMM as an example):

Own Stock $102

Sell Jan08 Short Calls for $15.10

Buy Dec 07 Long Puts for $9.85

The net result is a cost basis lower than where the stock is currently trading. If the stock continues lower, the bearish options offset the stock decline. However if the stock bounces sharply and I believe the stock is unlikely to drop below $100 per share I can recapture premium from the long put and leave my covered call position through to expiration. The likelihood is the position could yield a healthy 7-10% profit in just 67 days.

We wish you all a safe week ahead!

Stock & Option Trades