Only The Paranoid Survive

Andy Grove, the founder of Intel and one of the people I most admire, once wrote a book titled ‘Only the Paranoid Survive’. The basic message can be paraphrased as: Just because you’re paranoid it doesn’t mean they’re not out to get you. If you are interested in Andy’s take on his quote point your browser here.

Tonight, something’s not sitting well with me – it’s been too simple – too easy. Something that triggers alarm bells ringing in my head is when too many traders agree on something. It seems almost everyone I’ve talked to in the past few days expects the market to drop. People are even picking dates as if they need to hire a limo for the occasion. After all – we all want to enjoy the crash in style, right?

“Nelson! Put a bottle of Cristal on ice, will ya? I’m expecting some guests today – we’ll watch the crash on the large Cinema display…”

A friend of mine who’s been a professional trader for years tells me that a bunch of people in the pits are really scared. Nobody wants to make a move and they’re taking profits quickly. The tape today reflects just that. On top of that my wave analysis has been spot on so far, I got the puts I wanted, and now I guess I just hold those suckers into April as we must be fairly close to the top, right?

Wrong!

If there’s something I have learned as a trader is that overconfidence is the silent killer. It always looms out there, silently waiting, lurking in the shadows, waiting for that one day when you think you know something. When you put it all on the line, hoping you got the market by the balls.

“I know where the market is going to go. My wave count has been right and we are overbought to the max. Why would we rally from here? Possible but not probable, right?”

Wrong!

Let me tell you something. The market always has you by the balls – you’re only along for the ride, so stay humble as hell and never ever get too over confident.

Now that I’ve freaked you out a bit and probably have your attention, let’s get to what I want to convey tonight. Let’s look at the world with different eyes. As some of you know Berk and I have been trend traders and have been successful in trading the turtle system in the past. If you don’t know what the turtle system is – no worries – we’ll get to it in time, but for now all you need to know is that it’s a trend trading system.

Now, let’s take a completely different look at the SPX before I get to our wave count:

What you’re looking at is the SPY chart with two price channels (since the SPX chart has my wave count, but it’s basically the same). They are also known as ‘Donchian Channels’ and happen to be a key indicator for the Turtles. The idea is pretty simple actually – the Turtles had two systems:

1. Take positions on a 20-day breakout and exit on a 10 day breakout in the opposite direction.
2. If you snoozed through 1 then take positions on a 60-day (or 55-day depending on who you ask) breakout and exit on a 20 day breakout in the opposite direction.

The system has a few filters and there are stops and pyramid rules which we won’t focus on tonight – we’ll keep that for another day.

The point I’m trying to make is that a Turtle might have looked at Friday’s close and been completely comfortable taking a long position right there as it satisfied the system 1 rule. It even complied with the entry filter in that the previous touch was unsuccessful – again more about that at some other time. And so far that Turtle trader actually would have been profitable!

Now, granted – trend traders are a special type of rat that lives and thrives in areas of the market you might refer to as the Twilight Zone:

It’s that space somewhere between the markets into which most of us rarely venture, a world in which traders don’t care about being wrong. They care about being right just that one time when the market decides to be completely irrational. Trend traders are special kind –  and they happily fade whipsaws as just another opportunity to load up more. They take trades you would never even consider in your wildest dreams. If the market is overbought and you think it can’t go any higher they smile and buy some more. If you think the market is shot to hell and there’s no way it can’t go any further they are more than happy to take the other end of your trade.

Yes, trend Traders are wrong most of the time, but boy – those few times they are right, they make a killing. And that pays for all the little losses they incurred and then some.

So, how can we consolidate two different perspectives which appear to be almost orthogonal to each other? I could go at length here, but in my (and Berk’s) opinion – when it comes to long term strategy it seems that Elliott Wave Theory appears to wind up winning most of the time. It has served us pretty well in 2008 and I don’t expect it’ll let us down this year. And often you can actually consolidate the two approaches as there are times when the wave count indicates that a trend will continue despite most market participants getting ready to take profits. Except for those intrepid trend traders of course – they stay in until they have incurred enough losses telling him that the trend is over. I know – trend trading is not for everyone…

There are however times when the two approaches stand in conflict and tonight is such a situation. If nothing else I wanted to show you that, no matter what, there’s always somebody out there who’s got a system that claims that the truth is the the opposite of what you think it is.

So had it not been for a message I received from 2sweeties I might have just faded my paranoia and stuck with the wave count. However, this is what he said:

We have a situation with very compressed levels and support is very
close from where we closed.

Not much hope for big drops from the point of view of the odds.

Most frequent reversal longs are @ 928.25.

Below 917.81 the Frequency of Long reversal drops dramatically.

So, if tonight ES goes down, the odds are saying that it may reverse
around 917.

This is what he’s talking about:

As you can see we have a situation here. After tonight’s close we are faced with a congestion zone of long retracement levels. Not good – it’s possible that we’ll run into some heavy resistance tomorrow morning.

So, what do we do?

As good traders and stainless steel rats we adapt of course! Now, let’s get to my usual SPX chart and talk strategy:

Here’s our trusted wave count in its usual glory. At this point I assume that you have incurred at least some short exposure – either in form of long term puts or perhaps you actually shorted some stock or your favorite ETFs. Bottom line is that you drunk Mole’s cool-aid and expect the market to drop. This is what I suggest for tomorrow only (and maybe Thursday if conditions do not change):

Hedge yourself with an ES contract (or several based on your exposure) and hold it until we breach 907. It’s the perfect way to protect you against explosive rallies that might develop. The advantage of using a futures contract is that all of you, even accounts below $25k, are able to trade it and won’t be flagged as PDTs (pattern day traders – sounds almost kinky…). The day trading margin for one ES contract is around $6,200 last time I checked. If you have very small exposure you can also hedge yourself with an NQ contract – the day trading margin for that is around $4,000 – so you need that much cash in your account (plus a little more probably). At the end of the day you can sell it – what’s convenient is that those futures almost trade 24×7, but I would not recommend to hold it beyond NYSE hours.

If we breach through this RL congestion zone it’ll be safe to dump the contract and yes, you lost some profits but it’s comparatively little when considering the alternative of an explosive move to the upside. You just know the market makers will punish you on those spreads, especially if you’re tempted to drop your options and wait it out.

Of course other hedging strategies exist and I leave it up to as a trader to pick what suits your particular trading style and risk exposure. But I think that this is a very reasonable strategy and I can guarantee you that you get much better fills in the futures and that the market makers won’t screw you on bid/ask prices.

Here’s another approach Grednfer posted in the previous thread:

What I did (and this is the way I hedge) is buy the SPY Jun 700s puts & sell the SPY Jun 690 puts ……this can be done as a combo or spread. This a called a delta neutral vertical put spread. Neutral is selling about 10% more. This can be modeled in TOS under the Analyze tab.

As the SPY price rises, the puts that you’ve sold MAKE dinero. When Zero gives you the “GO” you buy back the sold puts and let the downward momentum explode into humongous profits. (thats the part I like)

While the SPY price is rising the net $$ effect of the trade will be zero but profit will grow on the “sold side” of the spread. There are various forms of the spreads for different purposes, but when I’m close to the top, but not quite there, this is what I do. You make money both ways, Which is sooooo cool.

In respect to the wave count really nothing has changed. We are on track and if we make it past that newly developed hurdle then we should be scot free and ready to bust lower.

One chart you need to see is the NYMO. Look how we’ve gone from one extreme to another – sure signs of a secular bear market – just as a side note. 120 is way way overbought – nothing new. But a trend trader looks at this and says – great, it might go higher! Remember there were folks that said that we would never touch -120 on the NYO as -60 is traditionally considered oversold. Well, we hit -130, so we might just hit 130 tomorrow. Nothing is impossible and only the paranoid survive.

That’s it for tonight – for the record: I am very comfortable with my trades and intend to hold them. But that does not mean I ever get complacent 😉

By the way, I’m switching the long term indicator back to down again as it’s supposed to reflect long term trading strategies.

Cheers!