Saturday, September 5, 2009

Size Reverses, Time to Retrench?

Stocks rallied on Thursday and Friday, despite continued rising unemployment levels. The late-week rally failed to move the averages higher on the week though. The S&P500 lost a bit more than 12 points and the Dow, a little more than 100.

What catches my eye is the reversal in the S&Ps weekly Size number. I wrote recently how the mid-term Size number was reversing and that it could be a tip-off that the market might be running out of steam. I also said that normally, I wait for the 10-week Size number to give me a more relevant signal. As the chart above shows, Size is reversing.

What Does It Mean?

In the simplest terms, Size shows how the stock price is acting against a moving average. When Size is rising, it means that the stock price is moving in a direction faster than the moving average is moving. It indicates strong momentum. When Size reverses and begins falling, it indicates that price is retreating to the moving average.

An Optimal Time to Sell Options

Sometimes when Size reverses, prices merely fall back to the moving average. This is especially true when strong trends are in place. Other times though, prices can suddenly move to an opposite extreme - and in a hurry. Depending on your risk appetite, should you wish to hold on to your stock for a long-term period, this is a great time to take some money off the table and selling options is a great way to do it.

Bank of America Example

Let's assume that you bought Bank of America stock recently for $12 a share. With the stock currently trading at 17.09, if you sell now, you would achieve a 42% profit. Not bad for a few week holding period.

Notice how your situation changes if you sell a January 2010 $15 call against your position. When sell the call, you are giving the call purchaser the right to buy your stock at $15 a share in the future. If the stock continues rising to $20 a share, then the call purchaser would have made a good investment. The call purchaser will pay you $15 for the shares and if desired, can turn around and sell them for $20 in the open market. You still come out looking pretty good though.

As you can see, selling the call option provides you with a cash inflow of $350. This allows you to take some money off the table but you are still holding your position. By receiving the $350, you are effectively reducing your cost basis in the stock from $12 a share to $8.50 a share. You will continue to hold the stock as long as it is not above $15 in January, when the option expires. If the stock is above 15, then you can either buy back the option and retain the stock. Or you could let the stock be taken from you at the price of $15. But as you can see, your percentage gain is now 76%!

What's more important than this outrageous percentage gain is the protection that you receive. As mentioned earlier, when Size is reversing, momentum is ending and prices will drift or change direction. By receiving the option income and reducing your cost basis, you have taken some profits off of the table and can more easily weather a downward move.

Don't Let Yourself Be Unprotected

If you have been participating in the market and have some gains, the time may be right to start taking a bit off the table or somehow protecting your gains. The world can change in a heartbeat and I don't want to hear you crying "could've should've.." Contact me to learn what strategies might best suit your particular situation. We are all different and do different things so no one idea is appropriate for everyone. One thing is clear though. You cannot take this Size Reversal lightly. While it's no guarantee that the market is going to turn as no indicator is perfect (especially when the markets are manipulated to the extent that they are). We always face the risk that the government or Federal Reserve will once again intervene in the marketplace and provide additional stimulus pushing the market still higher and higher. At some point though, this charade that many are calling the new bull market is going to come to an end. I suspect that the aftermath is not going to be pretty.

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