Wednesday, October 28, 2009

28/10: Markets lurch downward; NASDAQ suffers worst fate, down 2.67%

Markets today reminded traders of why the month of October has a brutal reputation for returns. The NASDAQ plunged 2.67% on heavy volume (2.65B), while the broad-based S&P500 surrendered 2% to 1042 and the DJIA slid 1.2% to 9763. The wide divergence in performance amongst these three indexes is striking, although not altogether unexpected: downward lurches are inherently accompanied by upticks in volatility, and NASDAQ components do have greater beta values than their DJIA counterparts. Also, the DJIA is a poor index due to inappropriate weighting of its components and its being based on only thirty stocks. One year charts, courtesy of Bigcharts, follow for the tech-heavy NAZ and for the trusty S&P, respectively:


My own experience today was one I'd rather forget: sharp losses on the back of a significant long position in November $42 QQQQ calls. For those not in the know (and I qualified as recently as a month ago, I'm almost ashamed to admit), QQQQ is an ETF -- an exchange-traded fund -- that seeks to mirror the performance of the NASDAQ-100 stock market index. Curiously, however, the correlation is not a perfect 1.

Of course, experiences like that of today are what ultimately lead to improvement in trading judgment and skill. Battle-wounds educate about the risks inherent to the market, reveal areas of theoretical weakness, and sharpen resolve (after one recovers from the chagrin and disappointment). Here's a 10-day of QQQQ; due to the strong, positive correlation between QQQQ and the NASDAQ and S&P500 indices, the chart is also an approximation of overall market activity during the time-frame:

After bearing the full brunt of QQQQ decline throughout the session, I did liquidate a part of my investment for the joint purposes of limiting risk and financing a new position in November $11 AA puts. This is a risky strategy to be sure. AA -- Alcoa, the behemoth aluminum firm -- closed today at $11.92 after a very significant decline of over six percent, on very strong volume to boot. Here's a 10-day of AA:

Yet, the move was soundly thought-through. After today's sharp decline, further deterioration at tomorrow's market open is a distinct possibility on 'technicals' alone -- that is to say, based on the dubious insight of only technical analysis. Quite simply, markets often extend the dominant trend of the prior session into the opening minutes of the new day, and this is particularly pronounced during sharp price movements that are accompanied by significant volume. Furthermore, tomorrow morning (pre-market) shall bring the release of U.S. 3rd quarter GDP growth, a critical value for the markets. Any disappointment will certainly exert tremendous downward pressure on stocks and may incite an immediate drop of 1 or 2 percent. Without the AA puts, I'd face a further precipitous decline in my account value (due to those ill-timed QQQQ calls) in the event of a poor GDP value (say, anything under +2.5%). Note, dear reader, that the market consensus is between +3.0% (many) and +2.5% (Goldman Sachs, as revealed today).

That said, the puts can certainly back-fire, and in a particularly acute manner to boot, given they're already fairly deeply OTM (out-of-the-money). After a decline of today's manner and magnitude (i.e. a decline where both the first and second derivatives of price are both negative, and where the decline occurs on sharply increased volume), in both AA and the general market, the risk of a reversal to the upside is considerable. Any upward reversal will bring sharp deterioration in any OTM, near-dated puts. Which are precisely what I now hold.

But, on the plus side, my overnight position is fairly well leveraged, with QQQQ calls providing upside gain and AA puts offering downside profit. My ideal move for tomorrow's session would be disappointing GDP figures leading to a sharply lower open, which would provide a handsomely profitable exit for the AA puts; followed by an appreciation of the market over the next one or two sessions from highly oversold levels, which would nurture recovery in the value of my QQQQ calls.

Good luck on tomorrow's markets!

No comments:

Post a Comment