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Lessons from the Pros

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Bailouts, Bankruptcies, and Bureaucrats

Thu, Sep 25 2008, 06:20 GMT
by Online Trading Academy Team

Online Trading Academy

We are living through an extraordinary time in the market; a watershed moment in which US capitalism as we have known it will be forever changed. Not since the Great Depression, has the government had to intervene on such a grand scale as to prevent a near financial collapse. Similarly, the repercussions will be felt for generations to come.

While the bloviating over the particulars of the Bailout plan continue in the nation's capital, the equities market continues to move lower - at least until Warren Buffett decided to invest in Goldman Sachs - despite all the efforts by the government to stem the flow of the financial crisis. As the politicians continue their wrangling over the specifics, the market remains unsettled over the lack of details, and time-line of the bailout plan. As more of these specifics are worked out, and perception grows that the plan will get done, I believe the markets should begin to stabilize, at least temporarily.

Looking back, the fall of Lehman brothers and near bankruptcy of the largest insurance company in America, AIG, precipitated the chain of events that lead to what now looks to be one of the most comprehensive government intercessions in over 70 years. Additionally, the shotgun wedding, some would argue, between Merrill Lynch and Bank of America, was part of the fallout. If this merger materializes, there will only be two former investment banks (now bank holding Co's) left standing, Goldman Sachs and Morgan Stanley. Readers may recall back in August, I mentioned that Lehman Bros. should be closely monitored, as their demise would have a large impact on the overall stock market. The reason I bring this up is to reinforce the notion that as traders, we should have some understanding of what is driving perception, because in the markets, perception is reality.

All the turmoil has elevated volatility to extreme levels. This in turn, has made day trading the futures market very challenging for newer traders. In the last two weeks, I've gotten many questions regarding calibrating stop losses for this type of environment. To address this question, one needs to understand that the same methods of following trends, support, and resistance still apply; the difference is in the velocity and the distance of the moves.

Traders must compensate for the higher volatility in several ways: First, if you're trading one of the more volatile contracts, say the Russell 2K E-Mini (TF), one should consider switching to the E-Mini nasdaq (NQ ), since it has about half the beta. Secondly, if you're trading multiple contracts, consider cutting back size while expanding your stop. As an example, if you're trading four contracts with a 10-tick stop, trade two with a 20-tick stop. Your dollar exposure is equal, but with this adjustment, now you're able to weather the faster moves. Lastly, this type of environment is not exactly conducive for new traders to learn in. However, if you can trade successfully in this setting, then you should have it easier when we return to a less volatile market.

In my last newsletter, I wrote about the new ICE Russell 2000 E-Mini (TF). Since then, I've received lots of email asking about my thoughts on the new contract, and if I'm trading it. Truthfully, I've been teaching since the rollover, and have not traded it as of Tuesday. I did get a chance to watch it closely for about two hours yesterday, and from what I can see it seems to be trading fine. There are times of the day when volume does get light, probably because we're still in the transitional phase.
During these times, slippage might become an issue if you use market orders, but other than that, it's the same old Russell.

This week's technical review will be brief, since the price of the Russell can be summed up in the hourly chart below.

Figure 1: TF Hourly Chart

The huge gap you see was the massive short squeeze caused by the SEC imposing a ban on short selling of financials, coupled with the AIG rescue. That gap was filled Tuesday as the uncertainty about the bailout plan lingers. The next important level to look at is 700 on TF, which I suspect will be breached sooner rather than later.

The bottom line: In late August, I wrote about the negative historical tendency for market in the month of September, which has played out to a tee. So now that the government is putting together the mother of all bailouts, is this finally going to get us out of this malaise? I think not. There may be a relief rally after the plan is approved by the legislature, but then the real assessment of how much this is really going to cost will begin to emerge, and it might not be pretty. This new paradigm will raise a new set of questions that we won't have answers to for many months. Moreover, the uncertainty of the upcoming presidential election will also stifle any advance. All in all, this crazy market - as many of you have been categorizing it - will remain crazy for a while. So know your environment, live to fight another day, and first and foremost - know YOURSELF.

Published on  Thu, Sep 25 2008, 06:25 GMT