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Markets Ready to Rebound or Ready to Drown?

Ever since the flash crash on May 6, stock investors have been jittery to say the least. For a few moments, the world looked like it was coming to an end. Fast. And then it took the markets about six weeks to deal with the aftermath of that move, delivering volatility to the markets in a way that left even the most experienced investors breathless. Finally, beginning in July, the markets gained their footing and eventually pushed up and beyond their pre-flash crash levels. So what happens next? And, more importantly, how does an investor deal with this roller coast of painful emotions?

One of the main methods of dealing with volatility in the markets is to get a handle on your sleeping point. That is, if you are staying up at night worried about your portfolio, then its time to reduce your exposure until you can sleep at night. This has many benefits above and beyond being well rested.

By being comfortable with your exposure, you will be less prone to react to the daily market gyrations and, well, do something rash. Investors who were overleveraged going into the May 6 crash had no choice but to panic and get out of their positions, many at a serious loss. Meanwhile, investors who had sold down to the sleeping point, while not necessarily happy with the selloff, were able to sit through the carnage as they were already comfortable with their exposure. Today, their losses are recouped, while the over-leveraged trader is most likely still stuck in the same hole they found themselves in the day of the crash. The sad truth is one of the best ways to save money for retirement is to not lose a lot of it along the way. Bottom line, if you are staying up nights worried about your exposure, its time to lighten up to the point where your emotions are no longer hair-triggered by the daily gyrations in the market.

In terms of the markets current state, are we in a situation now that warrants being comfortable on the long side (the famed Santa Claus rally), or is it time for these markets to rest? If there is anything that can be said for 2010, it is this: The market has done the unexpected. The summer is supposed to be quiet. In 2010 its been incredibly volatile. The bad news should be driving the markets lower. In 2010 bad news was, for the most part, a reason to rally. September is one of the worst months for stocks. September 2010 was the best September performance since 1939. In other words, there is no "normal" for this market. I'm inclined to think that if everyone is expecting "yet another Santa Claus rally", then 2010 is the year that ain't going to happen.

How to trade this? The S&P 500 just tested its key level at 1175 and bounced nicely. At this point I'm expecting more strength in the short term, but I'm keeping my eye on that 1175 level. If we turn around the first week in December and take out 1175 support, then look for the S&P 500 to make its way towards 1100 and the Dow to 10400 into the end of the year. To participate in this move, I would use that trigger to buy at-the-money January puts on the SPDR S&P 500 ETF (SPY). In 2010, the money has been made doing the opposite of what "should be happening" and I think its possible that trend takes us right into the end of the year.

At the time of publication, John Carter was short SPY December puts.

John is a Commodity Trading Advisor with Razor Trading. McGraw Hill commissioned him to write a book entitled Mastering the Trade, which was released in January 2006. Carter has also been featured on ABC Money. He and Hubert Senters founded and run the Trade the Markets web site.

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