In short, yes, there seems to be a very bullish head and shoulders formation in the short term. The chart below displays the head and shoulders, the white oval is the head and the rectangles are the shoulders. The period after the right shoulder is still to be determined; but if the left shoulder is an indicator, which the pattern suggests, the market is in for a 3.5% rally. The end result of this formation may put price at a very opportune selling point however. The debt ceiling playbook instructs traders to sell at prior highs. The chart below indicates that after the market hits prior highs it will bounce around for a few days then crack lower, but what else should market participants know before we fall off the cliff?

According to Barclays, “some policymakers appear less worried about this [fiscal cliff] outcome, in their view…economic damage will initially be limited while any equity market sell-off will spur a resolution.” It is too bad it takes a mini crash to get government working, but if that is what it takes traders might as well join in and short. The other side to this trade is a rather ominous one. Many folks in the financial world have been comparing the debt ceiling chart to today’s action. Straddles perform best in a down market with lots of uncertainty, should government actually fix the problem the market could actually get squeezed higher. If the market moves enough, straddles could still perform, for the downside in implied volatility is limited. University of Penn’s Wharton School of Business Prof. Jeremy Siegel claims that the Dow Industrials could rally 1000 points on a fiscal cliff deal. Either way, straddles win, as long as it is a big move.

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Author:  salernoma@mx.lakeforest.edu

Citigroup: With no clear impulsive moves off the highs, it really makes trading any stock that much more challenging. You never want to put your money on something doesn’t have a high probability of playing out. What I do notice is a larger triangle that could be playing out. This would mean that it bottomed at $21.40 and is now making corrective moves, as you can see in the chart an A-B-C-D-E triangle. These are like 4th waves in a way, that they are very frustrating to trade since they don’t have a clear path. The most likely scenario that is playing out is an E wave down that will target the $29-$27.50 region. A break above the declining tops line still doesn’t get me bullish at the time. My best recommendation at this time is to sit on your hands and watch it play out for more clarity.

Bank of America: This chart really isn’t THAT much better than Citigroup’s. With no impulsive moves off the highs it’s hard to have a clear picture of where it wants to go. What I do notice that is different from Citi’s is that it has cleared its declining tops line, and seems to be holding support along the way up. I might add it has also cleared the 50 and 200 moving averages. That’s a short-term bullish signal. What REALLY jumps out to me is the volume on the day…. 462.9M shares traded vs. its average 144.61M. That’s 4x its average! This is a signal that a breakout could be underway. So what might we expect going forward? I expect a small pullback to $10.20ish area and than blast off to $11.25. From there our next area of resistance is up at $12.15. For the downside risk… any pullback below $9.60-$9.40 makes me think twice about short-term higher levels. Conclusion: At this moment in time, Bank of America is a better buy.

Buying a straddle is a simple strategy that only involves buying the ‘at the money’ put and call. The combination of these two options create a spread and risk profile of extreme gains if the underlying product moves a lot. The risk to this trade is that the underlying product does not move or does not move enough to break even. This risk can be mitigated by looking at the relative price of options; implied volatility. Implied volatility can be used to determine the probability of moving a significant amount, along with the relative price of the contract. When one is looking to buy straddles, the optimal scenario is that implied volatility is low, however one has a strong thesis and conviction that the underlying is going to move a lot.

CBOE’s VIX, S&P 500 Volatility Index, is at three-year lows. This index is a measure of the aforementioned volatility. Over the last three years the VIX has had a range of $45, on the upside and $13, on the downside. Considering the VIX is currently trading at $16-ish, the low implied volatility criteria is checked, but what about conviction of a move?

The SPX dropped 16% during the debt-ceiling debacle. This precedence could be the foundation for the fiscal cliff trade. The chart below displays the SPX before and after the debt ceiling, and the chart below that displays the current SPX trend. With a few exceptions…the two charts mirror each other. Before the crash, the SPX rallied up to prior highs, or the highs established in the down channel. Perhaps if the SPX reaches there that would be the opportune time to put on duration straddles. Buying duration will increase the premium outlay, but if one could bet on anything it would be that government takes too long to figure things out under pressure.

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Author

salernoma@mx.lakeforest.edu