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Breakout Or Fakeout: What To Do In Range-Bound Markets


Even as the major indices started 2023 with a bang – the best January performance in four years (S&P 500 ETF (SPY) and Nasdaq 100 (QQQ) were up 9.2% and 13.1% respectively) – there is a debate as to whether this just another bear market rally or truly the beginning of a new bull phase.

From a technical point of view, the recent gains have been healthy and suggest it’s the beginning of a sustainable move higher. 

Today, I’m going to show you what the technicals are telling me right now – and where the market could be headed next…

Let’s get to it…

The Case for the Bulls

Market internals such as breadth have been good, new highs are outpacing new lows, and both the SPY and QQQ have not only moved above their 200 day-moving averages, but have also broken through the downtrend line that defined bear market through most of 2022.

All of this seems like great news for traders and investors alike – but there’s plenty of reason to remain skeptical and proceed with caution…

The Case for the Bears

Bears have pointed out how much of January’s rally was powered by short covering.

According to Goldman Sachs there was some $300 billion of “de-grossing” of bearish positions in what it called “the largest short-squeeze since January 2021,” when the major indices had a similar 15% move over a six-week period thanks to meme stocks like GameStop (GME) and AMC Theaters (AMC).

You can see a basket of 25 of the most shorted stocks has outpaced the SPY by 15 percentage points in January.

And many of these most hated stocks have been adding to their gains; names such as Carvana (CVNA), Upstart (UPST) and Roblox (RBLX) are up over 50% in February.

Here’s What Happens Next

If these were the only stocks posting gains, I’d also be suspicious of this rally’s sustainability… but remember, we’re seeing positive breadth across the board, with sectors as varied as housing, industrials, and emerging markets hitting 52-week highs of late.

Also, it is not unusual during the early phases of the bottoming process for the biggest gains to come from beaten down or low quality stocks with heavily shorted shares.

It’s worth noting that the names mentioned above – along with many of the recent big winners – are still down some 70%-90% from their all-time highs.

Another aspect of the rally worth noting is that not only were hedge funds covering shorts. Institutional money managers were also reducing long exposure – meaning they’ve been selling on the way up.

According to the Goldman Sachs report, the $300 billion in short-covering and the reduction of long holdings has led to $120 billion of de-grossing, leaving net exposure at just 65% of the five year average.

This lack of commitment may help explain why over the past week or two the indices have been whipsawing within a fairly tight range.

Over the past 12 trading sessions, the SPY has had nine reversals in excess of 1%, with four of them greater than 2%.

Basically, it’s been covering the entire 2.9% range on a daily basis.

This has made it difficult to have confidence in trade setups as breakouts have mostly become fakeouts.

Options360 has been handling this environment by being patient in initiating new trades and quick to take profits (and limit losses.) Thankfully there have been very few of the latter.

In fact, out of the 12 closed trades thus far this year Options360 has had 11 winners. Six of them have been bullish trades and the average holding period has been just 4 days.

For example last week we established a bearish put spread in Nvdia (NVDA). Two days later the stock dropped over 5% pushing the spread fully in-the-money.

While the position was still 30% from achieving max profit I decided to close it to lock in a 50% gain during the 2 day holding period. And good thing I did as NVDA shares quickly rebounded some 7.5% from last week’s low and the spread would now be out-of-the-money.

Until we get some conviction and can break the range one way or another, the game plan will continue to be patient on entries but quick to take profits.

But when we do, make sure you’re here to take part in all the action. Join Options360 today and never miss a market beat…

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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