Market Direction and Understanding Cautious Investing

Market Direction intraday continues to show the same pattern of small daily dips testing intraday support and a push back as investors still jump in. This pattern of the markets grinding higher in small steps indicates the continued concerns of investors, but also their belief that the market direction rise is still quite tradable. I thought today rather than going into studying the daily market direction action intraday I would look at some of the questions asked today by a FullyInformed forum member who asked question that basically concern cautious investing and what this means. If you are not a member of my forum, you can join here.

Let’s review some of his questions and look at some answers. I have edited his questions somewhat to fit into a Q&A type setting to make it easier to follow and understand. I have used his questions in two articles. This is the first article. His questions are in italics.

Forum Member Market Direction Investing Q&A

Question: Teddi, I appreciated the (daily) effort and the advice (on market direction). I agree with your statement of stay cautious but stay invested, but I think that it is actually ALWAYS better to ….”stay cautious but stay invested…” but with a caveat.

ANSWER: Just to be clear I believe there are different levels of caution to my strategies. If you read my portfolio strategy article here you can see that I spread by capital in 3 ways: 40% stocks, 30% bonds and 30% cash. When I believe that caution should be set aside for gains, I commit all my capital. For example starting in late 2008 and early 2009 when it was obvious to me that the selling from the bear market was overdone, I eventually committed all of my capital and all available margin to my positions. Again in July and August of 2010 investors were dumping stocks and doom and gloom pervaded but Bernanke has implemented QE2. This was not a time for caution. Again in August through to October 2011 as the market pulled back it was another great time to jump in with cash at the ready.

To understand investing is to understand market direction. In April I had written the article “Dance Near The Exits” explaining that Fed Chairman Bernanke wanted assets inflated. I explained that he had sent out party invitations to all investors but I was surprised at how few investors were attending his party. In this article which you can read here, I explained that “My approach has been to turn down the noise from the media, turn up the music from the Federal Reserve and stay with the trend. I know after 35 years of investing that there is rarely any point in fighting the trend. Right now the Federal Reserve has been pumping liquidity into risky assets and has been since the credit crisis. “

I went on to say “Once the Federal Reserve announced their intention to pump liquidity at an unprecedented scale they basically sent out party invitations to everyone with any kind of financial investment. When I got my invitation I thought it was obvious to everyone who could muster money for a financial investment that risky assets would rise in value, including commodities, stocks and other currencies and the plan was to create inflation.

In the same article I asked: “DID YOU NOT GET YOUR INVITATION? This announcement by the Fed was their invitation to bring your financial investment to their party. The Fed wanted to inflate your financial investment in risky assets, they wanted inflation, they wanted a lower US dollar and they want this party. When it looked like the party was going to slow down, and many “guests” started to go home, the Fed sent out more invitations to QE2 – their second “add-on” party. Like a sequel to a great movie, they coaxed everyone back to the party to inflate our financial investment portfolios further. After all the S&P is still not even back to 2008 highs, let alone the all-time 2007 highs. It is obvious to me that the Fed wants people to get their capital back. “

So to be clear, there are times when caution is not the best action to be taking. There are definite times when it is obvious that capital should be increased.

Question: If we are indeed at an inflection point, and all time highs certainly trigger a lot of “ooohhhs and ahhhhhs” – – much like Fireworks, which I actually loved as a kid and rarely see nowadays – – – technical analysis is indeed the best way to deal with such inflection points.

Are we at a HIGHER caution area now, Teddi, and how do we act differently if this is a measurement of a time to be MORE cautious than “normal.”

What is it that we might do here? Buy cheap puts if we are invested in many stocks in a particular indice (such as the S&P or are you weighted in the DOW? Or the Russell?).

Do, we lower our options contract numbers – – in other words, normally we are selling 10 and now we go to 5 to open?

Do, we sell DEEPER OTM on puts that we sell?

What you have touched upon is what is all about. Understanding the markets and knowing how to invest, what strategies to use and when to invest. Remember that sometimes not being invested is also a strategy. A lot of your questions are what I have answered each night in my market direction outlook for the next day. In those articles I have indicated, build your watch list of stocks, looks for dips and periods of weakness to sell puts against. Move to smaller positions and scale into those positions. For example if you are always selling 50 puts on a stock, move to 25 and do them in lots of 5 or 10. Pick your points of weakness to sell the puts against.

Market Direction Impacts 90% Of All Stocks

This morning for example the S&P started off with the market direction falling and then began to climb back. Wait and look for these types of opportunities. Remember that 90% of stocks follow the market direction.

S&P 500 market direction March 6 2013

S&P 500 market direction March 6 2013 5 minute chart

Below is Caterpillar Stock this morning. look how the stock followed exactly the same pattern right to the same time period, 12:00 PM. Then the stock bottomed at $89.52. The March 16 $87.50 put options which are just a little over a week away to expiry, were trading this morning for .53 cents. I sold 5 where normally I would have sold 10 to stay cautious but still invested.

Caterpillar Stock Mar 6 2013

5 minute chart of Caterpillar Stock March 6 2013

The 5 day stock 15 minute chart for Caterpillar stock for Feb 28 to March 6 is below. There are several strategies to consider including to only sell puts on dips or to pick your price point, say $90 and only sell puts when the stock falls below $90.

Caterpillar 5 day chart

The 5 day 15 minute Cat Stock chart

Over the past 5 days let’s look at two approaches an investor could consider to stay cautious but invested.

1) Put Selling Approach 1 – Sell only on Dips. Total contracts to sell 25. Put strike price is $87.50 for March 16 options expiry.

In approach one the strategy is to sell only on dips. On Feb 29 the stock climbed all day (POINT A) so no puts would be sold. On March 1 there was a big drop in the morning at point B, allowing for the selling of 5 puts at the $87.50 strike.

On March 4 another big dip at Point C and another 5 puts would be sold. On March 5 there was a dip late in the day as the stock moved lower all day and another 5 puts would be sold. Finally today, March 6 a dip by noon and another 5 puts could be sold.

In this first approach by March 6 I have sold 20 put strikes leaving 5 naked puts left to be sold perhaps tomorrow on a dip if there is one.

2) Put Selling Approach 2 – Sell only when Cat Stock is below $90 and only on dips. Put Strike is $87.50 for March 16 options expiry and the total number of contracts to sell is 25.

In approach 2, Feb 28 (Point A) would not see any Put Selling since the stock was above $90. On March 1 the stock fell to $90.13 (Point B) but not below $90 so again no puts would be sold.

On Day 3 however the stock fell below $90 so I could sell 5 or 10 put contracts at point C, whichever I am more comfortable with but I would not sell all 25.

The following day there was a nice dip at point D but the stock stayed above $90 so no puts were sold. Today however at Point E the stock had fallen back below $90 so perhaps I would sell another 5 or 10 puts.

In the second approach I have another 5 put contracts for selling in the event the stock falls again in the next couple of days.

Put Selling Cautiously As Market Direction Moves Higher

So while the overall market direction continues to push sideways to higher I am still busy growing my capital but it is through a careful Put Selling approach as I am taking a more cautious stance in Put Selling by reducing the amount of capital in use.

The key then is understanding what is meant by cautious investing. Consider reading today’s second article on market direction.