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Are We In for Some Short-Term Speed Bumps?

Round-number levels will be a major factor in the short term

by 3/8/2014 9:00:57 AM
Stocks quoted in this article:

Stocks got off to a rough start in March, as traders on Monday exercised caution amid escalating tensions between Ukraine and Russia. However, as geopolitical concerns abated, Wall Street heated up, with the S&P 500 Index (SPX) touching record highs in the subsequent sessions. However, as Todd Salamone points out, equity benchmarks are going into the week in overbought territory, and could run into some round-number roadblocks in the short term.

  • Why we're watching small- and mid-cap stocks.
  • How growing optimism could leave us vulnerable in the days ahead.
  • Rocky White investigates the leaders and laggards of the recent rally.

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.

Notes from the Trading Desk: Round-Number Roadblocks in Focus
By Todd Salamone, Senior VP of Research

"Stock investors appear to be in a win-win situation heading into Friday's jobs report. A disappointing release will almost certainly be dismissed due to brutal weather conditions last month, whereas a significantly better-than-expected reading could stoke some optimism."
-The Wall Street Journal, March 7, 2014

"$IWM Overbought and at a key round number with 'win-win' scenario the consensus mindset into today's employment number- - doesn't bode well"
-@ToddSalamone on Twitter, March 7, 2014

The next couple of weeks could test the upward momentum that began in early February, with equity benchmarks entering next week's trading in an overbought condition, similar to that when we entered 2014.

Additionally, other factors may come into play, such as round-number, century-mark levels, as well as round-number percentage gains on the iShares Russell 2000 Index (ETF) (IWM - 119.70) and the Dow Jones Industrial Average (DJIA - 16,452.72), which on Friday came within 75 points of its year-to-date breakeven (0% return) for 2014, after briefly trading above the 16,500 mark.

We are paying close attention to the IWM, which is a basket of small-cap stocks, a group that tends to lead during bullish market environments. While we are impressed with this group's leadership in 2014, short-term traders should note that this exchange-traded fund (ETF) enters next week in an overbought condition, as measured by its 14-day Relative Strength Index (RSI).

In fact, as you can see on the chart below, during 2013, the IWM tended to move sideways or experience slight declines when it entered an overbought condition similar to the present. Potentially complicating this situation for the bulls is that the IWM is approaching the round 120 level, which corresponds to 1,200 on the Russell 2000 Index (RUT - 1,203.32). Adding to the round-number significance is the fact that some major round-number percentage gains come into play from major pivot points. Specifically, 120 on the IWM is roughly triple the lows in 2008-2009, as it carved out a major bear-market bottom, and double the correction lows of 2010 and 2011 (see second chart immediately below).

As those of you that use the RSI indicator in your analysis are likely well aware, there is no written rule that an overbought condition is resolved with a sell-off. In fact, the IWM rallied in the fourth quarter of 2012, and again in January 2013, despite its overbought condition. However, with round-numbers coming into play, from a price- and percentage-gain perspective, the IWM may be more vulnerable than usual to choppy price action or a pullback in the days ahead.

Daily Chart of IWM since November 2012

IWM 120 is roughly triple the '08-'09 lows and double the '10-'11 lows

Monthly Chart of IWM since March 2007

Meanwhile, the S&P 400 MidCap Index (MID - 1,388.95), another key index in terms of its leadership role in this bull market, is bumping up against a round-number level too. In fact, MID 1,400 is double the 700 level, which proved to be significant in early 2009 and 2010. The MID traded in a volatile manner around 700 for months in late 2009, and this area marked support during two corrective phases in 2010.

700 was a key level early on in the bull market, and 1,400 is double this level

2009-2010 Daily Chart of MID

As major benchmarks test areas of potential resistance, short-term traders who were extremely optimistic ahead of the decline in January and quickly turned into "Nervous Nellies" at the bottom in early February have once again changed their tune. The current optimism among traders, who turned optimistic as the market made new highs, leaves the market vulnerable to weakness in the days ahead.

One example of this optimism is in the equity options market, where buyers of calls have done so at a rate of more than 2.25-to-1 in the past five days, approaching levels that existed prior to the market peaking in late December/January. As you can see in the chart below, this same group quickly became disenchanted with individual equities around this time last month, when the five-day, equity-only, buy (to open) call/put volume ratio sharply fell to a five-month low. A second example of short-term optimism is anecdotal, and highlighted in the excerpt we pointed out at the beginning of this report regarding the "win-win" situation equities are in, as perceived by some market watchers ahead of Friday's employment data.

ISE, CBOE, PHLX 5-Day Equity-Only BTO Call/Put Volume Ratio with SPX since July 2013

With short-term optimism among traders returning, and major benchmarks trading around potential resistance areas, the bullish momentum that began in early February is at risk of slowing, increasing the likelihood of choppy price action or downside movement in the coming days. The upside is the intermediate-term and longer-term outlooks continue to favor the bull case, as there is still a big short position and a healthy amount of portfolio-protection trades outstanding, which could put a floor on pullbacks.

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