Healthy Pullback or Financial Doom?

The next few weeks will tell us a lot about how the market's recent downturn will play out. In the meantime, it's important to trade defensively.
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CHICAGO (

TheStreet

) -- Is this the beginning of the end? That's the question many investors are currently pondering following this week's selloff. And although the market went a little further to the upside than we expected, we are currently seeing the market give back some of the recent gains. In my opinion, this demonstrates one of the beautiful aspects of options selling. We have a larger margin for error. The market can move against us temporarily, but we can stay the course if we believe in our analysis and nothing fundamental has changed from the time we initiated our trade.

What I am wondering now is whether this is nothing more than just a healthy pullback and profit-taking in a market that has run a long way very rapidly, or whether it's the beginning of something more sinister. Ask a bunch of coaches what wins games, and they will all give you the same answer: defense. I feel that now is certainly the time for a defensive posture when it comes to the markets.

We always say here that once everyone has turned bullish that's when the market turns, and I think that is what we are experiencing now. Sure, we have seen some great improvement in some of the economic data that have come out in recent weeks, and sure, many companies are boosting their outlooks, and sure, we have sensed a lot of optimism recently.

One must remember, however, that many difficult challenges lay ahead. Today's

ADP employment report

underscores this. After all, how high can the market go while we continue to lose jobs? And the numbers this morning caught the market off guard. Do more surprises lie ahead? What about the banks? All of the concern this week regarding West Coast banks, specifically

Wells Fargo

(WFC) - Get Report

, will continue to weigh on the market. And although it appears that the Wells Fargo story has been put to rest, one must wonder whether these banks are properly capitalized and whether we'll see another round of equity-raising and therefore shareholder dilution? Will this in fact prove to be a double-dip recession?

Looking at other markets certainly is giving us some clues. We have seen crude oil once again fail at heavy resistance in the mid-$70s. Bonds continue to trade higher with interest rates at the lowest levels in months. Obviously, investors at this point are willing to accept these ridiculously low yields rather than put the money at risk in higher-yielding asset classes. And lastly there's the greenback. All of this recent talk about the dollar "tanking" has not yet come to fruition. The dollar index has managed to hold the bottom end of its trading range, and I suspect it will continue to do so. As a matter of fact, as we continue to see money being pulled from higher-yielding currencies such as the Canadian dollar and the Australian dollar, I think we will see investors going back to the greenback as the flight-to-quality trade becomes more visible.

Now I am not saying that I am expecting financial Armageddon. We have a lot of things moving in the right direction now. But challenges do remain, and we must position ourselves accordingly. We will continue to look for short-delta opportunities in the commodities sector as well as the corresponding currencies. This trade has worked well in recent weeks, and I will stick with it unless something fundamentally changes and I am proven wrong. In addition, we will hold our short call positions in the

S&P 500

futures (although remember that trading futures and options is risky, that such investing is not suitable for all investors and that investors could lose more than their initial investment.)

Although I feel confident that we will see more downside, I always think it is best to wait and get some clarity on the market's direction rather than force a trade. I think the next couple of weeks will determine whether this is a buy-the-dips situation or whether the bears are taking firm control, creating a sell-the-rallies situation. I do feel that 956 on the S&P 500 will be an interesting level to watch and may provide a decent short-term put-selling opportunity. This is the level at which I expect buyers to return if this rally is going to have hopes of continuing. Stay tuned on that one.

It's no secret that September historically has not been kind to the market, and we are not expecting an exception this year. If profits have not already been taken, now is without a doubt time to play strong

defense

and protect positions with puts. Lets see what happens with the return of volume to the markets. And remember, often the best course of action is to tread lightly and sit on the sidelines. Having no position

is

a position.

-- Written by Matt Zeman in Chicago

.

Matt Zeman is a principal with Lasalle Futures Group and chief market strategist for Time Means Money.Com.