A Very Important Lesson

Yesterday we saw yet another steep decline following expiration week. We have been bearish on the market for a while now due to the distribution days that have been adding up. Nevertheless, it is important to remain objective here and not let your market bias skew reality.

Reality is that while the market is technically not in very good shape here, there has been an underlying propensity toward dip buying that is not easily seen in the daily charts. Every time the market takes a dive, no matter how shallow, dip buyers have been right there putting a floor under the move keeping prices elevated.

If this were occurring in an environment of exuberance then we would discount the dip buyers as hopeful, yet gullible traders. The truth is though, that this has been one of the most hated market rallies on record. Nobody trusts it and this has been reflected by the fact that the options market has seen a put:call ratio near 2:1 for months now. In other words, everyone is afraid of a decline, so they are hedging against it.

So how to interpret the dip buying in this situation? If the majority of market participants hate the rally and distrust it so much that they are shorting it, then it must mean that dip buyers represent smart money, not hopeful retail traders. And like the old Dean Witter commercial, when smart money talks, the market listens.

Robert Carver explained how this works very nicely. This is a keen observation about how the market works, so pay careful attention. This can earn you a lot of money over the years if you understand it and act on this information (highlights are ours):

As the market falls, more investors get nervous and buy more puts, causing more short-selling of the futures to hedge the new puts and it becomes a waterfall. But, the effect is only temporary. As prices move lower and lower, put holders, who have seen their puts rise in value while their stocks decline, sell their puts and then "return to the scene of the crime" to buy more stocks, which are now on sale. This causes the market to immediately rally back, often to new highs, and leads to short covering in the same derivatives which caused the decline in the first place. Short covering pushes the market higher, creating an equal effect on the upside. Hapless bears who took the initial decline as a sign that the "big crash" had started are then forced by rising prices to buy back their losing positions, pushing the market to new highs. And so it goes .... As long as stockholders are afraid that the market will go down, it can't go down for long. The puts create an "ocean of liquidity" which floats the market. And, as long as investors are buying puts, this self-fulfilling prophecy insures the market against a meltdown.

But, you might say, "What happens when investors stop fearing a decline and forego buying puts?" Ah, grasshopper, therein lies the ultimate top in stocks and the beginning of the next crash.

So what is the lesson for today? Since options traders bought puts at a 2-1 margin yesterday it means that healthy investor fear persists and that this decline is likely to be short lived. When the day comes that options traders start to buy calls on the dips instead of puts, that's when we need to look out below.