By: Costas Bocelli — May 5, 2016
How to Take Advantage of this Sell-Off Right Now
A Quick Note from Chris: Today I’m really excited to welcome back someone who many of you will remember from back in our days at Tycoon Research and the Institute for Individual Investors, Costas Bocelli.
For the past few months, I’ve been engaged in a quest – trying to get him to write a weekly article for you guys in True Market Insider. It was a tough battle, because Costas has been enjoying a “semi-retired” life with his family in a new home on the South Carolina coast. He wasn’t looking for work. But I know he’s still active in the markets and still has a ton of knowledge and ideas to share, so I basically annoyed him until he gave in.
You’ll find his first contribution below, and he’s come out of the gate strong with an actionable trade idea for you. Look for an article from Costas every Thursday going forward. If you want to reply to this email and welcome him, I’ll make sure I pass your note along to Costas. Enjoy!
When Chris and the team at True Market Insiders approached me to see if was interested in writing a guest column for True Market Insider, I was not only honored, but eager to have the opportunity to share my knowledge and analysis with a group of old friends.
For those of you who aren’t familiar with me, I’ve educated and guided thousands of self-directed individual investors for more than six years. Whether it was running my options research advisory service, creating educational products, or hosting live interactive webinars, I took great pride in knowing that I’ve made such a meaningful impact for so many people.
So to be here — writing a guest column — and accepting the responsibility as being a “trusted expert” is something that I hold dearly and will continue to do so.
I also enjoy sharing investing strategies and actionable trading ideas, so my hope is that the time you spend with me becomes a valuable resource that you can rely upon.
In fact, in just a moment, I’m going to reveal an actionable trade idea that could net you a healthy rate of return over the next two-weeks or potentially position you to buy a high quality stock at a meaningful discount to the current market price.
But first, let’s take a look at the overall state of the stock market, shall we?
Since the start of the year, the stock market has been on one whacky roller coaster ride, befuddling even some of the most successful money managers on Wall Street.
The market plunged into correction territory during the first six weeks, creating a significant oversold market condition.
Then, like the flip of a switch, the market abruptly reversed and has rallied in eight of the past 11 weeks.
But now that many of the major indices have recently approached their previous all-time highs, a wall of resistance has stalled the momentum.
Have a look at the S&P 500; the index recently came within 2% of its all-time high…
But to get a clearer picture of the current market landscape, we need to dive into the internal market — or breadth — the True Market Insiders approach.
There you will find the clarity to see that short-term market conditions have recently become dangerously overbought.
Have a look at the percentage of stocks in the S&P 500 trading above their respective 50-day moving averages. For simplicity, when the reading is above 70%, the market is excessively overheated. And when the column of X’s flip to O’s (like what’s just occurred) and then drops below this level, supply usually takes control, sending markets lower.
S&P 500 %10 Week (50DMA)
But here’s the thing if you’re a bullish investor…
You actually want to see the overbought condition alleviate itself, because clearing out excessive bullishness rebalances the market landscape and contributes to a healthy and more sustainable longer-term trend.
And that seems to be what’s likely playing out right now.
But looking at the longer-term picture, our number one primary indicator of market risk — the NYSE bullish percent index — suggests that demand is still very much in control.
The NYSE BPI is basically a compilation of the percentage of stocks on the New York Stock Exchange that are on a point & figure buy signals. Without getting too deep into the details, the bulls are generally in control of the market when the recent column is in X’s (like it is right now). And like the %10 week indicator we noted earlier, market conditions do not become excessively overbought until it rises above 70%. So while the short-term market condition may have become overbought, the longer-term market condition is still relatively balanced.
Putting it all together into an actionable trade idea
So here’s a quick recap:
We know that there’s a higher probability that the market is in “sell mode” in the short-term as an overbought condition works itself out.
We also know that demand is still in control looking at the medium to longer-term as long as the NYSE BPI remains in its current column of X’s.
The thing that’s impossible to know with certainty is how long or how severe the near-term weakness may become. That’s where watching our indicators and instruments come into the equation, and we’ll be sure to keep you apprised every step of the way.
But as you know, there’s always inherent risk when you invest your hard earned dollars. It comes with the territory.
The key to building wealth, whether you’re an investor or a trader, is being in the right place at the right time.
And the approach that’s taken at True Market Insiders is to uncover the most suitable securities and investment ideas by carving up the market universe into distinct sectors and quantifying performance using various measures of relative strength.
Having said that, and coupled with the current market analysis we just laid out, now let’s get into the actionable trade idea.
The security I’m targeting is Home Depot (Symbol: HD).
Fundamentally, the stock is on strong footing.
Q1 earnings season is now in full swing, and the aggregate consensus forecasts for S&P 500 operating earnings and revenue growth are downright awful. Earnings are expected to contract 9.1% from the same quarter a year earlier, while revenue growth is also expected to contract 1.2% from a year ago.
But Home Depot’s prospects are far brighter.
The company is scheduled to report financial results before the market opens on Tuesday, May 17. Earnings are expected to rise 11% or $1.34 per share from the quarter a year earlier. And revenue is also expected to increase 6.4% or $22.2 billion from a year ago.
And the technical picture is just a solid — in fact, according to our research, it gets a top-notch rating. Some of the contributing factors include favorable readings on price trend, relative strength versus the market and relative strength versus its sector.
Here’s a look at the daily price chart on HD (recently trading at $134 yesterday morning)…
The trade idea:
With HD recently trading at $134 per share, sell 1 HD May 130 Put contract for $1.50 for every 100 shares of stock that you would consider purchasing as an investment.
The idea is to sell the Put option and collect $150 per contract ahead of earnings. The Puts expire three days later on Friday, May 20. If the stock remains above $130 on expiration day, you keep the cash, which results in an annualized return on risk of about 28%!
If HD does indeed trade below $130 at expiration, then you’ll be obligated to purchase the stock at the strike price. But since we collected $1.50 upfront, your cost basis is reduced to $128.50 (the dotted line above).
The bottom line is that selling out-of-the-money Put option contracts is an effective strategy to reap high returns on your investment cash with the potential of buying stocks at discounted prices.
The key is to focus on high quality fundamental securities that have strong relative strength technical attributes.
Until next week,