Let’s Talk Strategy

SWN, PCU, and DIA Protection

Dear Bottarelli Research Member,

Let’s talk strategy.

We’ll begin the discussion by reviewing my predictions from past Bottarelli Research alerts. If you recall, the market trends revealed that August and September were historically bad months for the major market averages. During these two months, I received a plethora of questions like “should we buy puts on the Dow?” My response to these questions was an adamant “NO!” In numerous alerts, I told you that the major market averages would see new highs before witnessing any significant sell-off. As the month of September came to a close, that prognostication was dead on the money, as the Dow broke to new 52-week highs by shooting past the high-water marks it set in May.

It was around this time when I began to warn you about a pending market sell-off. If you remember, the Dow dropped a whopping 900 points immediately after setting new 52-week highs back in May — and what’s why I warned you that October (despite being a historically strong market month) could be one of market weakness. Now I openly admit, after the first 16 calendar days of October, that thesis has not come to pass. But that doesn’t mean the prediction is wrong — not by a long shot. In retrospect, it appears that I was a tad bit early in switching gears and calling for downside. But now that the Dow tiptoes towards the 12,000 level, we could begin to see signs of the bulls losing strength. Case in point, take a look at the chart of the CBOE Volatility Index (VIX).

Commonly known as the “fear gauge,” the VIX is a trader’s tool used to pin-point market turning points. When the markets are going up, fear comes out of the market — which subsequently drops the VIX lower. On the flipside, when the markets are going down, fear comes back into the market — which subsequently shoots the VIX higher. Here’s why this is so important: If you look at the 6-month VIX chart below, you’ll notice that the index touched the 11 level back in May — which marked the beginning of that month’s major market sell off that lasted all the way until mid-June. Over that time-horizon, the VIX nearly doubled, going from 11 to 23 as the Dow dropped 900 points. This 11 level is critical because the VIX is once again approaching these levels as I write. This means that the markets are so fearless, the impending threat of a sell-off should be drawing near.

This is why I wish to remain steadfast in our downside positions like MNST November 40 Puts (BSQ WH), SBUX November 37.5 Puts (SQX WU), and OSTK November 20 Puts (QKT WD). If the major market averages do begin to sell off, these are three chart formations that indicate that the selling pressure could be very severe (as a quick recap, Starbucks has an upside gap to fill, Monster has a pending options back-dating scandal about to blow up, and Overstock is fighting a reduced retail environment going into Christmas).

Now don’t get me wrong — just because I’m skeptical of the market rally doesn’t mean I refuse to profit off it. That’s why I’m holding longer-dated calls on PPH November 75 Calls (PPH KO), which turned profitable today, while taking quick call winners on plays like PEIX November 17.5 Calls (PFQ KW) and ALK November 40 Calls (ALK KH).

As I write you today, the Dow is trading for 11,986, only 14 points away from the magical 12,000 level. So the key here is to participate in any continued upside strength — while at the same time being protected against any major market sell-off. And the way we do that is establishing upside call positions in companies that represent safe-havens in times of selling pressure. At the same time, we also establish a protective downside “hedge” on the Dow. Here’s what I mean:

The first safe-haven company is Southwestern Energy (SWN — NYSE), a natural gal and oil company operating in Arkansas, Texas, Louisiana, New Mexico, and Oklahoma. I mentioned them to you last week as a prime beneficiary of any up-tick in natural gas prices leading into the winter months. As you can see from the chart below, my thesis has been proven correct, as SWN is making an upside move that could extend past the 200-day moving average at $34.00.

If we take on a longer-term approach on SW (with the possibility of adding to the position on any price dips) I feel we could be handsomely rewarded in November or December.

PLAY: Buy the Southwestern Energy December 30 Calls (SWN LF) at or under $4.40, good for the day. Place a protective stop loss at $2.50.

The second safe-haven play is Southern Copper (PCU – NYSE), a metals conglomerate that deals with mining, processing, and producing copper, molybdenum, zinc, silver, gold, and lead. Without question, PCU gives you the best all-around exposure to any up-tick in precious metals, which will rally on any market downside. As you can see by the chart, PCU has just broke above the double-top formation it set in early August and again in early September, which signals that higher prices are on the horizon.

PLAY: Buy the PCU December 50 Calls (PCU LJ) at or under $3.50, good for the day. Current bid/ask spread is $3.20 to $3.40. Place a protective stop loss at $2.20.

And finally, I want you to add some protective DIA put hedges. These will act as portfolio insurance in case we get a massive sell-off at the 12,000 level (as indicated by the VIX chart from above). Make no mistake, these puts should be viewed as nothing more than an insurance policy that’ll cover your back-side in the midst of a market sell-off. Much like car insurance, the hope is that you never have to cash it in — but in the rare case that you need it — you’re glad you paid the monthly premiums.

Think of it like this. Say you decide to treat yourself and get a new car. You trade in your old 1993 Ford Escort and buy a 2007 BWI 760i, sticker price $118,900. What’s the FIRST CALL you make once you make that purchase? Well, if you’re like me, that call goes directly to your auto-insurer, telling you them you need to increase your car insurance policy. Well my friends, the Dow at 12,000 with the VIX at 11 represents driving your new BMW 760i with your old 1993 Ford Escort insurance policy. If something goes wrong, you will be in a world of hurt. So let’s not make this mistake in our portfolios. For $1.55 per contract, I think it is well worth the money to establish a protective put position in the DIA. If you agree with my analysis, then here’s the trade:

PLAY: Buy the DIA November 120 Puts (DAW WP) at or under $1.60, good for the day. Current bid/ask spread is $1.40 to $1.50. Do not place a protective stop loss at this time.

Lock and load

Sincerely,