This market needs a rinsing!

Can you feel it?
Yesterday was the key.
The Nikkei was up huge. Asia was strong.
Europe was up. Alcoa had good earnings. Our market? Garbage!

Never mind all the oversold readings, etc. When a market reacts poorly to good
news, it is telling you where it is headed. The psychology has flipped. Good
news is ignored, so-so news is bad news, and bad news is a disaster. As Dr.
Steenbarger correctly pointed out in his article Monday, fear begets fear.

Things that have been ignored until now because the market has been going up
will now be front and center. The avian flu? It has been spreading out here for
a year and a half (I am in Asia), but nobody in the US talked about it because,
hey, the market was going up!

Now it’s going to be under your bed and in your face, because the market is
going down. This is how the psychology flips.

What this market needs is a good healthy “rinse” to the downside to clear away
all the overhead pressure. I would like to see it down 3- 4% in one go before I
get interested in going long anywhere. Volatility is jacked up, but is still low
historically (all those funny markings are “overbought” readings, meaning the
market is oversold).

The tape is ugly and the charts are uglier:

So how do we play it? I’m tempted to say “hit a
bid, make a friend,” which is probably true at this point. Options-wise I would
say this: If you must go long something, use a bull spread, a call ratio spread,
an above-the-market long butterfly or condor, something that incorporates the
(relatively) elevated levels of implied volatility into the strategy, but
doesn’t put a lot of risk on the table in case this thing plunges.

For bears it is a bit more difficult, because outright put buying is tough with
implied volatility up (relatively) like it is. However, you do have a friend.
When the market gets scary, the implied volatility skew kicks up, as people
reach for out-of-the-money put options as a form of catastrophic insurance. Us
this to your advantage by constructing bear put spreads where you buy an at or
slightly in-the-money put, and sell those out-of-the-money puts at much higher
volatilities as panicked longs reach for them. (Hint: when it comes to this
strategy, buy first, sell second!)

Joe Corona

Joe Corona is a 23-year veteran trader who
makes his living trading options and other derivatives. Mr. Corona has been a
floor trader on numerous exchanges including the CBOE, CBOT, and CME. Joe most
recently spent 4 years as Head Trader for Market Wizard Tony Saliba at Salibaco,
a proprietary trading firm. He  has also been an options instructor for the
International Trading Institute  where he has trained hundreds of options
and derivative traders for major institutional trading desks worldwide. Joe is
the Director of the Asia Pacific  region for CDLS Consulting, LLC which
specializes in trading U.S., European, and  Asian options and derivatives.