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Know Your Market ABCs -- and Qs

Here's a setup you can put into place before the Nasdaq-100 starts to uncoil.

"It is usually dangerous to buy stocks on the third day of an advance. The market generally moves for two or three days in one direction and then either rests or reacts." Want to guess when that was written and by whom? The answers are: 1903 and S.A. Nelson, in The ABC of Stock Speculation. I keep a copy of this book on my desk, having done so for the past 35 years. It's a must-own for any stock market investor or trader. Nothing much has changed over the past 107 years on Wall Street as far as the machinations of prices go. Read this book for proof of that comment.

The Nasdaq-100 tried its best on Tuesday to successfully complete its third up day in a row. Mission accomplished by 5-plus points, though for a while that effort was in doubt. Reality at some point has to be put into stock prices if I am to believe the bond market. The bond market is acting like I should have a helmet on my head for fear that the current value of the stock market is about to take another unpropitious fall sometime soon.

What the market tends to really whack when things get going on the downside are stocks with relatively high price-to-earnings ratios and no dividends to be wary of (as short-sellers must pay the dividend to the owners of the shorted stock borrowed). The Nasdaq-100 has more than a few of the stocks that meet these criteria. My NDX chart is showing coiling action. Coiling action precedes volatility expansion. Volatility expansion tends to coincide with stock price declines, though the relationship is not 100% valid.

The trade: Sell short 100 QQQQ at 45.50 and buy 2 QQQQ October 45 calls for 1.90 points ($380)

TST Recommends

One way you can speculate on the Nasdaq-100 is through the PowerShares QQQ Trust (QQQQ) . The "Qs" comprise all of the stocks of the Nasdaq-100. Consider speculating on the potential volatility expansion of the Qs by employing a strategy that I call a dynamic synthetic put. This combination includes stock as well as options, designed to be delta neutral and gamma positive.

The dynamic synthetic put I prefer is one that is long the QQQQ October 45 calls two times for each 100 shares of the QQQQ that you short. This setup is close to being delta-neutral and is gamma positive. You would be buying the October 45 calls at 23 volatility level. That 23 volatility level I think will be near or at the low ebb of the volatility contraction. That 23 level should coincide with the point where the Qs begin to uncoil. Once a stock or index begins uncoiling action, volatility expansion almost always commences.

Price direction after the uncoiling of the underlying stock or index is not known, but whichever direction it takes, the options volatilities begin to expand. If one is long options at that expansion point, they will find that being long option premium is the right position to have on. Owning 1 additional call allows for the position to be basically that of a delta neutral long straddle, where you can make money as long as the underlying stock or index moves dramatically enough in one direction.

At the time of publication, Skip Raschke held no positions in the stocks or issues mentioned.

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