Condor Options

We’re going to be brief with our usual short-term market outlook this week, and devote most of our analysis to the bigger picture. After Friday’s final-half-hour pop, we again have tentative buy signals on the 60-minute chart—but on a daily basis, the S&P 500 remains oversold, daily and weekly momentum are still negative, and implied volatility has, on average, been slowly but steadily rising. Institutional players have been selling into any rally attempt, and it remains to be seen whether the distribution will get worked off in an orderly fashion or end in a capitulation blow-out.

With all major support from the past seven years now in the rear-view mirror, we have to examine a multi-decade chart for clues about where the next short- to intermediate-term bottom might lie:

The chart above (click to enlarge) plots the S&P 500 Index monthly since 1980, on a logarithmic price scale. The closest support below Friday’s closing value comes at the 61.8% Fibonacci retracement of the 25-year secular bull market from 1982 to 2007. The index dipped within 2 points of that line on Friday, which may have something to do with the end-of-day recovery. Despite what some hard-core technicians claim, however, Fibonacci ratios don’t have magical power; although plenty of traders buy (sell) precisely at Fib support (resistance), the older and broader rule of thumb is that support/resistance kicks in after the market retraces approximately one-third, one-half, or two-thirds of the prior move. The full two-thirds retracement level for the ’82 to ’07 run is 588.

The 1982 low is particularly interesting because it touched a mega trendline drawn through the lows of 1932^* and 1974. The only time that line was breached (the only other time it was even touched, in fact) was in 1942, in the months after the United States entered World War II. Today that trendline is rising through the SPX 530 area—about 22% below Friday’s close.

Another potential support level, however, sits well above this trendline and just above the two-thirds retracement level. The low made in 1996 wasn’t a major technical consolidation in the context of the 25-plus-year period we’re looking at, but, at around 605, it’s reinforced by the fact that it’s near a major round number.

To summarize: We’re seeing signs of a short-term rally emerging again this week, but it would take a great deal of momentum to overcome the long-term technical damage. In case of a continuation down or a reversal off a dead-cat bounce, the areas where we’re looking for support are around 665, 600–605, 588–590, and 550.

Not surprisingly, the stocks underlying our March positions have been buffeted this past week, but they’ve held up better than the broader market on a percentage basis—and that’s one of the main reasons we chose them. Let’s look at the details:

IBM March/April Double-Diagonal

Last week we were concerned about IBM rallying strongly towards the short strike of our adjusted call position, but we expected some consolidation—and got more than we really wanted. The stock dropped back along with market, verging on a downside adjustment before recovering late Friday to close at $85.81. The position is under pressure, but as of Friday’s close, we were still looking at an unrealized gain of about 11%.

PG March/April Double-Diagonal

In an effort to reduce whipsaws after our roller-coaster ride in January, we’ve been waiting for a closing price below our adjustment point to trigger an adjustment trade. Although the rally Wednesday temporarily negated the end-of-day adjustment trigger from the day before, another drop below the threshold within a couple of days was grounds for an intra-day adjustment.

When we entered this position, we chose a wide vertical spread in order to generate a credit, and thus protect ourselves from any possibility of incurring a loss purely from a drop in implied volatility. (A net credit means that the premium we received for the short options paid for all of the premium in the long legs—so no matter how much that long premium shrinks from a contraction in IV, we’re covered. Of course, this by no means eliminates our delta risk.) But that wide spread puts our adjusted trade at a disadvantage, because the expiration risk curve of our new double-calendar position dips below breakeven in the middle.

We had planned to bolster the position, and free up margin, by rolling the call side down to a calendar spread at 45, once we were sure that PG wasn’t just going to spring right back up. Now that much is clear, but market conditions have deteriorated to the point where we have good reason to exercise patience. Given the level of uncertainty in the market right now, and the attendant implied volatility, we’re not in any hurry to add gamma and vega. Even without our planned follow-on adjustment, we have a good chance of getting back pretty close to breakeven by the end of this week. And we still might go through with the second step if PG stabilizes early in the week.

At the moment, the unrealized loss on our base position (2 contracts per leg) is about $46. What that means in terms of ROI depends on how we calculate our basis. If we use the theoretical total capital at risk, which is equivalent to our total margin requirement and thus our current capital allocation, we’re down 3.4%; based on practical real risk (the probability of our short calls expiring in the money is less than 2%), which is closer to our original capital allocation, we have a 5.2% unrealized loss. Members who want to free up cash don’t have to wait for an adjustment alert to buy back the short calls, but it’s important to account for having done so when following any future adjustment alert that includes this step. (Autotrading subscribers note: Manually altering an autotraded position may result in failure to have future trade alerts executed—before doing anything of the sort, we strongly suggest you discuss the implications with your brokerage.)

^* In addition to actual prices for the entire history of the S&P 500, Prophet Charts provides data for a model of the S&P 500 Index going back to the beginning of 1928.