“Cautiously Fearless”

VIX Signals the Worst is Behind Us

Dear Bottarelli Research Member,

Last Thursday, as the Dow dropped 139 points, we were able to maintain mostly all of our upside positions without suffering any major damage. But then came Friday…

And although the Dow dropped 120 points on Friday (13 points less than Thursday), it proved to be a terribly brutal sell-off for all of our open positions. Make no mistake, Friday’s sell-off unlike anything we’ve experienced before. All told, the two-day, 259-point drop left nothing untouched. Even the market’s one and only safe-harbor, the metal and commodity plays, are witnessing sharp pullbacks today.

What exactly happened on Thursday and Friday? Was it a “correction” or a “reversal” or just a “pullback?” And more importantly, what do we do coming out of this two-day sell-off? Let’s start by defining a few terms (definitions pulled from Investopedia.com)

Correction: A reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index. Corrections are generally temporary price declines, interrupting an uptrend in the market or asset.

Reversal: A sudden change in the price direction of a stock, index, commodity or derivative security. A reversal can be a positive or negative change against the prevailing trend. Technical analysts watch for these patterns because they can indicate the need for a different trading strategy on the same security.

Pull-back: A falling back of a price from its peak. This type of price movement might be seen as a brief reversal of the prevailing upward trend, signaling a slight pause in upward momentum. Often pullbacks are seen as buying opportunities after a security has had a large upward price movement. It is important, however, to analyze closely any pullback as it may be a sign of a definite trend reversal or a slight pause in the upward trend, each having very different trading implications.

Without question, I think Friday’s selling pressure got way out of hand – and this lead to panic selling. You cannot deny the fact that the markets are trading within the parameters of an established up-trend. The rash of new 52-week highs in virtually every major market index proves this. For that reason, I think we witnessed a “correction” and not a “reversal.” In other words, I don’t think we saw a change in the overall prevailing trend. After all, over 70% of S&P 500 companies have either met or exceeded earnings expectations in 2006. So we’re still in a strong market. But like any up-trending markets, we’ll see corrections and pullbacks, like last Thursday and Friday, as prices sold off from their peak.

Having said that, what can we learn from last week’s down-move? And more importantly, how to we tactically approach our trading moving forward?

For one, it’s quite clear just how concerned the market is about inflation. For that reason, we’ll refrain from entering any major positions heading into a Fed meeting. The moves are just too unpredictable.

Tactically speaking, I think we need to be “cautiously fearless.” In other words, we cannot allow that two-day panic “correction” to shake us out of the markets. Over the longer-term, I still like each and every upside position we had open. In fact, I may re-enter some of these plays here at these depressed levels. And yes, the markets will turn around. Case in point, just look at the most powerful trading tool used by CBOE floor traders – the VIX Volatility Index (VIX).

The VIX acts as a “fear gauge.” It rises when the markets experience big-time sell-offs (which translate into more fear) and it falls when the markets rise (which translates into less fear). As you can see from the chart, each time the VIX has experienced a huge rise, it has always come back down shortly thereafter. It’s this reason why I think the worst is now behind us.

As far as this week goes, I’ll adopt the “cautiously fearless” approach and look for both upside and downside plays – especially on those strong stocks that I feel got hit much too hard. Tactically speaking, I don’t plan to load up the ledger this week – but rather dabble in some positions where the risk/reward is squarely in your favor. I’ll also monitor the two open positions we have, the eBay June 32.5 Puts (XBA RZ) and the LMT June 70 Calls (LMT FN). But above all, the one thing you should NOT do is let two days of panic selling shake you out of this market. There are tremendously exciting companies out there, and I plan to trade alongside every one of them!

Now, more than ever,

Lock and load!

Sincerely,