Measuring broad investor sentiment is an inexact science. I rely upon research reports and blogs, talks with other investors and clients, and a series of technical studies I have honed over the years.
Over the past three weeks I have become more bullish as markets have marched higher, taken out resistance levels, and moved in synchronized manners. Many have questioned whether I reacted late to a movement that has already occurred. After all, the Dow is 43% above its March low and 15% above the slight pullback that ended in early July. With such large moves, is there anything left to gain by being long?
Facing such a logical question, I began thinking about the events of the past two years. In reality, the rally is so large because the sell-off was so brutal. If you examine the entire trend of the bear market, a new perception shows that the recent rally is a small bounce in an ongoing process.
Before the housing collapse triggered a credit crisis that would eventually make over our capitalist system, the Dow peaked at 14,164 on October 9, 2007, began a long grind lower, and eventually collapsed into a panic low of 6,547 on March 9, 2009. This results in a total bear market loss of 7,617 points.
Knowing nothing goes down in a straight line forever, we should expect to see rallies along the way. A common way to gauge expected price targets is by using Fibonacci retracement levels. Doing so shows that the 43% rally from the low has been impressive, but has not retraced even 32% of the prior loss. A powerful countertrend should be expected to recoup anywhere from 50 to 65% of prior losses. For now, the most recent rally is nothing more than the first stage of an ongoing saga.
Relying upon these retracement levels presents opportunities to trade. Each level is a key resistance where prices will stall, attempt to gauge direction, and then move sharply. This past Friday offered a perfect example. The 32% retracement stands at 9,465. Off a better than expected employment report, the Dow moved sharply and traded as high as 9,437-28 points from the first retracement level. Unable to push higher, the market pulled back and the Dow ended the day 95 points from the barrier. Over the coming weeks, I expect this process to repeat. If the Dow can break above this resistance it will quickly move toward 10,300. However, repeated failures open the way for a consolidation toward 8,700.
The dilemma of looking to profit from expected swings without knowing the direction can only be solved by the option market. By using a long straddle, which involves owning a call and a put with the same strike, we benefit from dramatic moves as the gains from one contract overwhelm the losses from the other.
To benefit from swings in the Dow, we can purchase options on the DIAMONDS Trust (DIA). Using the September contracts, we can buy the at-the-money DIA 94 calls (DAV+IP) for $2.25 and the DIA 94 puts (DAV+UP) for $3. At a total cost of $5.25, we benefit if the Dow trades above 9.925 or below 8,875 at expiration. Since my expected price range is outside of these numbers, a correct prediction will yield profits.