Dear Reader,
So much for Black October!
The Dow Jones broke above 10,000 this week. That’s a level that has the same importance as gold at $1,000 an ounce. And if you’re thinking that’s because it’s a nice round number, you’re right. That’s exactly it. Traders focus on round numbers. And as traders crowd around these round numbers, so they become important levels of support and resistance.
But this is about more than that. This is about history – the not-too-distant past. It’s about revenge.
Just consider that the last time the Dow crossed this 10,000 line it was doing so in the other direction – DOWN – and doing it rapidly. It was wiping billions of dollars off the value of people’s wealth. The most ferocious week of the recent bear market so far.
That was 6 October 2008 in a week when the Dow Jones index fell 1871 points or 18%. Over here in London, we had it even worse... with the FTSE down 21% or 1048 points.
But now, the mood is different. This time, crossing 10,000 is a victory. Revenge on the Bear.
Back then fear ruled the markets. Where is fear now? According to the “fear index”, there is no fear.
What the “fear index” tells us about investors in October 2009...
The fear index, by the way, is the Chicago Board Options Exchange Volatility Index - or VIX for short.
Traders call it the “fear index” as it is really a measure of how much investors are willing to pay in terms of options “premium” to protect their portfolios. When investors are fearful and so they are buying lots of index “put options” (which make money as the index falls), the VIX goes up. When investors are complacent and carefree, then the VIX falls.
If you’ve been reading The Right Side for a while, you may remember the VIX trade my colleague Theo looked at back in the summer... back when fear was still in the memory...
Back then, Theo had the idea that people should take out an insurance policy for their portfolios. Something that would pay you money if the market really started falling... but that meant you could still keep on holding the shares you liked whilst the market was rallying.
This was a good plan and it still is. But Theo wanted this insurance policy to kick in if things got really ugly. They still could and Theo has his insurance in place.
So far, of course, the market has not shown any signs of the kind of ugly behaviour that would cause Theo’s “insurance” to pay out. The market has been going up and the “fear index” has been going down…
I’ve taken a look at this idea again recently. And for me, there’s a line where I’d certainly be looking to get my insurance policy. You can see it on the chart above.
Look at the horizontal green line I’ve drawn on at 40. You can see that from the start of 2009, the VIX had consistently been held above that 40 level. Each time it fell to that level, it would bounce off it and head higher again.
That is, until the beginning of April... when the VIX finally pierced the 40 level... and has kept going lower ever since. Fear has been slipping away.
I think this 10,000 level on the Dow Jones is critical to what happens now in the stock markets. And it dictates whether or not we’ll need portfolio insurance.
Any bad news that comes out and causes investors to start “running scared” again could well set the VIX index off higher again. And that’s the trade I’ll be looking at.
Of course, as you can see from the chart, it has a way to go yet. But I just feel that whilst the VIX is down below 40, then we don’t really need to get too worried about stock markets. It’s a round number that traders are looking at.
If the VIX breaks back up through the 40 level that has been acting as resistance, then it could move a lot higher quite quickly.
So you could look at setting a ‘buy stop’ order at just above 40 on the VIX. I’ve got one in place already. It’s the level that I feel I’d like to have a little protection against my portfolio, should The Bear rear up once more and the market starts tanking.
Right now the VIX is trading at 22 – a long way from the danger level of 40. Everything continues to be rosy in investors’ minds. The VIX is trading below both its 50- and 200-day moving averages.
What we’re looking at is a chart of near fearlessness... where investors have hardly a care in the world.
Greed rules the markets... time to insure?
These days the markets are being driven by utter greed. And it’s not surprising. Many investors stood by and watched the market rally from the 6 March lows, never quite believing it was real, waiting for another major correction that hasn’t happened yet. So now, everyone is jumping in to shares.
And that could be a little worrying. I don’t think we’re quite at the top at the moment, despite the little wobble in the Dow today. If we were at the top, then there would be no bearish opinions at all. Everyone would be bullish. And they are not. There are still fund managers urging caution. When those last few commentators and fund managers throw in the towel, then the market could turn down.
As for me, it’s not ready to get off this train yet. Stick with your good quality stocks for now... trailing your stop losses higher as the shares go up.
But keep in mind a VIX trade. And I’m also seriously looking at some cheap out-of-the-money FTSE ‘put’ options too. ‘Puts’ increase in value as the index falls – and you can place a trade with a strictly limited risk.
That’s a strategy that I saw used to great effect by my colleague Riccardo Marzi in his Events Trader service recently. He placed the trade on 29 September, betting the FTSE would fall. Three days later his readers cashed out to bag a very impressive gain*.
The message is: Just consider some cheap portfolio insurance.
I for one can’t shake off that fear that the market may have gone up just a little too far, too quickly. And for me, the words Black October are still very much in the memory.
At the very least, expect there to be some battle around the big, round Dow 10,000 level, just like there was around gold $1,000. It could be that this level will not hold just yet...
Good investing,
Frank Hemsley
For The Right Side
Editor’s note: Make sure you take a look at Theo Casey’s latest recommendation. It’s another forward-thinking idea that you’ll not read about anywhere else – he calls it the “rewind trick”. This could hand you gains of up to 117% from the “new oil”*. Details here.
* Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Seek independent advice if necessary.
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