Bulls May Panic -- and Traders Could Get Trapped

By Jeffrey Cooper  AUG 18, 2009 9:50 AM

It won't be 1987 all over again -- but the echoes are impossible to ignore.


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You may find yourself living in a shotgun shack
You may find yourself in another part of the world

- "Once in a Lifetime," Talking Heads

Experience shows that, if one foresees from far away the designs to be undertaken, one can act with speed when the moment comes to execute them.
- Cardinal Richelieu 1585-1642

This is how options expiration week started out in 1987: It was hard to get short on a large gap down open that saw little in the way of a snapback. That was true yesterday with the SPYder (SPY) closing near where it opened at 98.

While it is expiration week, and the market can do anything, if we don’t see a strong snapback after the first 40 minutes or so of trading today, it will indicate the options expiration is for sale. This could create as much fear in the bull camp about losing half their gains quickly as the fear about being under-invested dominated the psychology prior to Friday. Things could get out of control. Quickly.

One of the factors in the 1987 debacle was that arbs shorted puts promiscuously to pocket premium in what was a persistent 5 month advance and it blew up in their face. The big players may be short 100 Spyder puts and don’t want them to be redeemed. But the cycles could pin them instead of them pinning the SPYder to the 100 web.

With Baidu (BIDU) and Google (GOOG) down over 15 points apiece and the usual suspects leaving large range gaps and possible island tops, it suggests calls are heavy on the tape in the go-go names -- and traders may be trapped.

The news started breaking with the cycles last week, with the consumer sentiment numbers; and after the close on Friday, the fourth largest bank failure ever occurred.
Though many in the mainstream media looked to disappointing earnings from Lowe's (LOW) as the culprit for Monday’s sell-off, the level of the market was set many hours before the open in Asia. We know where to look for the sun to rise. The market is taking its hue and cue from China. The range was elaborated hours before the open: we know where to look for who’s directing traffic.

It's not that I'm looking for anything like the amplitude or magnitude of a 1987 crash, but as you know, the cycles I'm looking at do project downside vulnerability into September/October. I don’t know what the level will be if accelerated volatility erupts, but the level of the market is less important than the risk. Risk has been underpriced. The whole rally was based on the idea of recovery, not earnings, which weren't based on increasing revenues for the most part.

It looks like the bulls kept shorting puts last week to drive the market up and added late Friday to prevent the market from collapsing. It backfired putting the market in a vulnerable position unless the S&P can offset 100% of yesterday's decline.

It's important to consider that legitimate reversals usually occur from down opens after a large rangedown day, not up opens. A big down open would be a cover shorts after the first hour. A gap open that can offset 1000 S&P will buy the bulls some time. It was very difficult to get short and stay short in 1987 as the market was oversold quickly beginning expiration week. It was very difficult for bears to think about getting short yesterday with the market flat-lining after the open so the market is vulnerable to unwinding further.

The great unwinding in 1987 began on a lunar eclipse on October 7. We just had a lunar eclipse on August 4th. The crash in 1987 occurred apx 6 months from a low preceding a persistently aggressive rally. We had a low in March followed by the most persistently aggressive rally in 70 years. September will be 6 months from low. It is interesting that the 27th trading day from the August 7th peak (so far) is September 15th, the anniversary of the day the market came unglued in 2008 when Lehman Brothers failed. The 27/28th day from late August high in 1987 was early the lunar eclipse when the crash commenced.

The August 7th turning point still stands as the high. Importantly, converting price to time, August 7th was 666 days from the October 11th 2007 top. The S&P March low was 666 of course.

Yesterday, the S&P hit 90 degrees down in a tick opening down 20 points to 980. The normal expectation would be for an attempt at support the first time tagging 90 degrees. But you never know how long it could last. 180 degrees down is 950-ish. At the same time the 50 dma is 945 while 50% of the range from the July low is 944.

Consequently, you can see the potential for a cascade if the confluence of support at 945 to 950 is snapped. 944 is also the January high. A break back below those double tops will trigger a lot of stops as prior resistance is supposed to act as new support. If it does not, there will be a lot of folks trying to get out of Dodge at the same time.
Trading Lessons:

No positions in stocks mentioned.

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