Differentiating Between An Irrational Market Or Strong Bull Market Trend?

These past two weeks have been tough as an options trader. Differentiating between trading an a possibly irrational market or bull market trend is sometimes very difficult to assess. We all know that the stock market can push us to extremes and then, just when we "give up" and "give in" the turn happens.

Timing is really everything.

Blow-off Top or Pull-Back?

Most traders I talk to are in one of two schools of thought right now. Either you think this is the best shorting opportunity for the next 2 years or you are convinced that we are now in a new bull trend that could take the S&P 500 well above 1,500. It's pretty much split down the middle honestly.

Whatever camp you are in there are some key stats that are glaring and cannot be brushed under the rug:

1) The VIX closed the week below 20 for the first time since last July.

2) S&P 500 is three standard deviation points above its 20-day moving average.

3) AAII Sentiment is near extreme levels at 47% Bullish compared to 29% Neutral and 23% Bearish.

4) S&P 500 contract short interest has declined nearly 32% - no more short squeeze?

Stick to Your Guns (And Indicators)

Will a top come soon? Maybe (hopefully) but who the heck knows right. I know I have been getting itchy to trade more as I've been mostly in cash for nearly a month now. Not that I don't want to trade, but I think that better risk/reward ratios will come soon and I'd rather have cash on hand to make those trades.

During bull market trend's like this I find that keeping an eye on the indicators is best. They can and often stay over-bought for weeks but eventually they do break and divergence will be the early warning signals. Look for momentum indicators to drift lower even though the market will continue to move higher.

  • Bill Place

    Yes tuff it is, btw, loved your video tonight

  • http://www.jetwake.com JETWAKE GLOBAL

    Well it has been about as exciting as we can stand it from Oct.4, 2011 to Jan.25,2012 ... ready for a nice vacation!

  • Dale Hagglund

    After watching Jim Cramer last night, I'm convinced that he is drinking the same Koolaid as Obama and Bernanke. Cramer is convinced that we are in a solid Bull market, and that the economy is in full recovery. I am not so easily swayed into that line of thinking, but with continued QE, and low interest rates, I think that the markets could see another upward push, not because things are safer or more valuable, but because our dollar continually becomes weaker. My guess is that we are seeing the first signs of inflation in the markets, check out the correlation between the money printing by the Fed, and the Bull run of the market, and there is little doubt that the growing US debt bubble is growing in size. It may be delayed for a period of time, but eventually, the debt bubble is going to burst, and that will be the time for the shorting party.
    I remember thinking the market could never go as low as it did, now I think the opposite is true for the high that is still coming.

  • Derrick

    I always try to remind myself that the "market can stay irrational longer than you can stay solvent" and "don't fight the tape". Yes, I agree that the economy is not in great shape and the stuff in Europe is ugly BUT at this time the market is ignoring that and until it does, you need to adjust your trading style. I think this year is going to be a different year, perhaps more trending market, than last year which was a mean reversion type market (i.e. chop).

    • Kirk

      @Derrick, Very good point - that should all be on our wall in front of our computer :)

  • brian

    more money is lost trying to predict the top. I learned long ago to wait until an actual reversal happens and then if there is a real bounce or not. Sure is a toss up lately but I sure see a lot of people thinking its short term overbought but an pullback is a buy which makes me nervous

  • http://www.offroadfinance.com W-at-Off-Road-Finance

    Given the odd divergence between VIX (>20% most of the time, all though not right now) and realized vol (0% last year) I'm surprised there isn't more interest in selling vol in this environment. Or possibly some combination of short S&P, short vol - on the theory that if the market moves as much as VIX says, it won't be up.

    What do I know, though? I'm allergic to options...

    • Mark Pey

      @W-at-Off-Road-Finance, I think the overall sentiment here is "disaster fatigue". We've heard the Armageddon case for 4 years now (debt, housing, unemployment, Europe) and while we have not done anything to improve those structural problems, people are just weary of hearing it. New bad news has less and less impact. With vapor volumes we can't have a real bull, but "upwardly-biased sideways" is probably a good enough call.
      On Iran, the US and Israel want war (it's a major engine of the US economy) but Iran just doesn't fit the script. It's not "isolated in the world" as the US keeps claiming, in fact it has very powerful friends like China and Russia. The Japanese and Koreans are telling the US that they need Iranian oil. India has said they will swap gold for it.
      Speaking of gold, I've been a buyer since 2004. But central banks desperately want to limit people's love affair with shiny stuff, they need them to love their paper (currency, stocks, bonds) so the naked shorting and other games will continue. CBs need to let the compressed spring out though so will allow another 15% or so up year, but will use things like more CME margin hikes and other smackdowns to prevent any real melt-ups. Interesting work over at SK Options on the "long overnight/short daytime) trade that arbs the LBMA/NY money center manipulation/repression against Asia bullishness and accumulation.
      Oil price is unhinged from supply/demand, and is routinely bid up in the futures by the same people who sell the physical. Phil at Phil's Stock World has got this dead right. So demand down, supply up, if the hinging factor is Iran then the bulls may be disappointed.