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Lessons from the Pros

The Two Most Crowded Trades (Oil and Financials) Continue To Unwind

Thu, Jul 24 2008, 06:12 GMT
by Online Trading Academy Team

Online Trading Academy

Crowded trades have a tendency to unwind in a violent manner. This process is currently underway, as oil and the much-maligned financial stocks are seeing a huge reversal of fortunes. Over the last two months, all of us have been aware of the surge in oil prices because it has affected us directly, in the way of higher gasoline prices. Also, when depositors - who were not certain how the FDIC (Federal Deposit Insurance Corporation) works - started hearing rumors that IndyMac bank was on the verge of collapsing. They rushed in droves to their local branches, withdrawing every penny they had entrusted to that institution, causing a run on the bank. This drain of funds led to the bank's near-term demise, prompting federal regulators to takeover the mortgage-laden concern.

In a related move, the Feds were once again busy trying to prop up another one of its government-sponsored enterprises: Fannie Mae and Freddie Mac. By providing a safety net to these eight hundred pound gorillas of the mortgage industry, once again, they've succeeded in averting a disaster. This action, along with changing the rules on shorting these stocks, gave short sellers the impetus to begin covering the very profitable positions they'd been holding for many months. So much so, that the financials had the biggest one week rally ever.

In regard to the oil market, demand destruction was cited as the main cause for the sharp decline (almost $20). It seems that $4.00 a gallon gas has finally driven people to change their driving habits here in the United States. Additionally - in a temporary move - China is pulling one million cars off the road prior to the summer Olympics, in an effort to control their wretched pollution.

All in all, these developments have resulted in a spectacular rally in both the financial stocks, and the overall market (particularly in the small caps). In past newsletters, I've written about the so-called, "wall of worry" and the "crowded" trade. The takeaway for traders from these themes is two- fold:

1) Don't chase trades. One should not get caught up in the emotion of the moment. When the market has been running, and you're not aboard, relax; another bus will be around the corner in 15 minutes. Markets rarely move in a linear fashion.

2) Take the macro economic views out of your DAY TRADING. If you let the media and economists steer your thinking, you'll be ill-equipped to capitalize on intraday trends. Remember, you're seeking to make money today, and to that end, only today's price action will pay you ...TODAY.

Since last week, I've received numerous emails from students who are incredulous that the market has been so strong. How can this be? They go on to cite all the bearish news and go through the litany of doom and gloom scenarios. They then tell me that they've been going long the QID (Ultra Short QQQ) and OIL (Goldman Sachs Oil fund) because that's what will do well if their logic pans out. Sometimes it's hard for a logical person to reconcile what's going on - on Main Street to what goes on in the world of financial markets. In addressing this issue, I'm reminded of the words of the famous British economist, John Maynard Keynes, who stated, "The market can remain irrational longer than you can remain solvent." At some point, rational thinking does prevail. Unfortunately, for those that don't understand this concept, it's often too late.

In this week's technical review, we'll first look at the chart daily of the ER2 (E-Mini Russell 2000) below. This small cap index has been hands down the leader in this rally. It's moved up a staggering seventy-one and a half points since last Tuesday's low. As of the close on Tuesday, it's sitting at the level from which it broke down (old support, new resistance), in late June. Shorting this contract in the last four trading days has been an exercise in futility - not to mention, very expensive. This may soon change though, as the market, in my view, has gotten ahead of itself.

In the Hourly chart (shown below), we zoom - in to get a better view of the near-term resistance (in yellow) which is roughly the 719 to 720 area.

It's been quite a run and the question now is whether all the short sellers have been squeezed out. I believe for the most part they have, which translates into some type of pullback or consolidation.

In summary: We are more than half way through the earnings season. So far, banks and brokers have reported horrendous earnings - which were widely expected - and the stocks rallied. In other sectors, it's been a mixed bag. The Nasdaq 100 has been a big laggard so far this week, due to some disappointing earnings releases from Apple, AMD, and SanDisk - just to name a few. We have some inflation numbers due to be released on Friday, but the focus will remain on the durability of the rally in financials. These types of rallies rarely just fizzle out quickly. As I noted earlier, I do expect some type of corrective move here, it might be 10, or 15 points in the Russell, as it's gone parabolic in the last two days. This, however, will be another buying opportunity.

Until next time, I hope everyone has a profitable week.

Published on  Thu, Jul 24 2008, 07:24 GMT

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