1235 Next Target For S&P 500 Reversal?

01/21/11 10:17:03 AM

by Donald W. Pendergast, Jr.

Is this really the top of the massive upswing that started way back in July 2010? Probably so, but will the support level near 1235.00 in the S&P 500 hold back a strong wave of selling pressure?

Security: .SPX, SPY, ES
Position: Sell

It's been an amazing bull run for the Standard & Poor's 500 since it made its major low back in early March 2009 at 666.70. Since then, this key large-cap stock index has managed to tack on an additional 629.40 points (a nearly 95% gain) as of Wednesday, January 18, 2011. Any way you look at it, it was a run to remember. There is a slight possibility that the index will find support sooner rather than later, making yet another run to new post-crash highs, but it might be more prudent to instead see where the next strong support level is. Here's a brief look at the daily chart of the .SPX (Figure 1) along with an idea on how to play the possible strong downdraft that may be about to be unleashed.

FIGURE 1: SPX, DAILY. That lonely bearish candle way up there at the top looks awfully lonely, and there's a high probability that it will soon have some brothers and sisters on the ride back down toward major support near 1235.00 to 1240.00.

Graphic provided by: MetaStock.

Graphic provided by: WB Detrend RT EOD from ProfitTrader for MetaStock.

Nothing too complex here in Figure 1; we see the appearance of a fairly large bearish candle -- the biggest one in nine weeks -- at the end (or presumed end) of a substantial uptrending move, one that according to the WB EOD RT detrend oscillator (bottom of chart) had been gradually losing momentum for the past six weeks.

It wouldn't be surprising to see more follow-through on this potential reversal, and by using three common technical tools, we can plot a general area of chart support on the daily chart. The medium-term uptrend line (red dashed line) may act as a temporary support level, as may the 50-period exponential moving average (blue line). They're both in the same general price zone on the chart -- near 1240.00 -- and that's a price zone that also coincides with a third technical tool, which is the Fibonacci confluence support area, one formed by two different degrees of trend, which also happen to reside right near the 1235.00-1240.00 area.

So, no big surprise here -- there is likely going to be some sort of meaningful technical support for the S&P 500 somewhere in the vicinity of 1235.00 to 1240.00.

With that knowledge and $2.00, you can ride the bus to the mall (if the mall hasn't been foreclosed on and if the bus driver hasn't been laid off by a cash-strapped public transit authority) and count the number of "For lease" signs. Is there a way to actually put that knowledge to use to perhaps make some money if the .SPX decides to make a rather quick run down toward 1240? Maybe.

FIGURE 2: SPY. Simply type in the desired stock ticker symbol in the Thinkorswim "Analyze" tab, and you can then use the multifaceted "Add Simulated Trades" feature, as shown here. Once on this section of the platform, you can easily run various price/time/volatility scenarios in order to help build rational and potentially profitable option strategies.

Graphic provided by: Thinkorswim.

As of January 19's close, you could buy an SPY March 2011 $129 put option for about $3.75 ($375 plus commission). If the SPY (the exchange traded fund that tracks the movement of the S&P 500) makes it down to $124.00 by February 7, 2011, you'd have an open profit of about $259 before commissions, assuming a 3% increase in implied volatility. That's a fairly optimistic scenario, but if this is a major reversal under way, the SPY should have little trouble dropping to major support within a couple of weeks or even sooner. See Figure 2.

With long option positions, you need to give the trade some room to breathe in order to stay in the position on a minor reversal against your desired trade direction, so in this case, you may want to progressively trail the daily chart of the .SPX/SPY so as to allow the trade to develop. If the option dwindles to half of the value you paid for it, consider selling it and waiting for another opportunity. Conversely, consider selling it for a profit if you see anything near 1240.00 on the .SPX daily chart.

If you put on multiple positions near 1280, you could always scale out half or more of your puts near 1240.00 and then trail the rest with a tighter trailing stop. With long options, however, you may just want to get in the habit of closing positions out near key support/resistance levels, being happy to walk away with a reasonable profit rather than letting accumulated profits slip away because you decided to hold on for a longer-term move that never materialized. In a directional option trading plan that uses a long put or call, you're usually far better off to grab profits on the first significant move to support/or resistance, as time decay and Murphy's Law always seem to diminish the chances for a subsequent swing or trend move to materialize in time for the option to gain additional profits.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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1235 Next Target For S&P 500 Reversal?

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