Analysis, Perspective, Trading Strategy

At the Edge of Chaos: Stocks Are Looking Over the Abyss. Are We in a Bear Market?

Editor Joe Duarte in the Money Options

January 23, 2022

It’s always darkest before the dawn.  And the oversold market could certainly bounce back at the drop of a hat. 

All of which means that I would not be surprised to see a huge short covering rally coming Sunday night in the futures market and carrying into Monday.

But make no mistake about it. The bulls are showing signs of being close to throwing in the towel for what could be an extended decline as fears of the Fed’s rate hikes finally take over the market’s psyche. 

Last week I noted that the action in the options market suggested that something big was brewing. I also detailed the possibility that the market makers were protecting their accounts.

Unfortunately, I was correct as the action in the stock market took a turn for the worse. 

Of course, the big question now is what comes next. And with the Federal Reserve widely expected to deliver a surprise interest rate increase at its upcoming meeting, it is plausible to assume that the selling is just beginning.

In the meantime, it’s also possible that the market rallies once the Fed meeting is over and somehow the algos talk themselves into believing that it could have been worse.

So, are we in a bear market? It’s always a possibility. Certainly, the odds are above average when the major reason for stocks breaking down is fear of the Federal Reserve raising interest rates.

Still, as I discuss directly below, the market is ripe for some sort of oversold bounce.  But honestly, it’s a tough call and much remains up in the air.

As a result, it’s not a bad idea to be prepared for any outcome. Indeed, the guiding principles of any trading plan remain:

• Don’t fight the Fed
• Don’t fight the market’s momentum and
• If a stock does not get stopped out, keep it until the stop gets hit

Welcome to the Edge of Chaos:

“The edge of chaos is a transition space between order and disorder that is hypothesized to exist within a wide variety of systems. This transition zone is a region of bounded instability that engenders a constant dynamic interplay between order and disorder.” – Complexity Labs

For more on how to develop a trading plan and how to approach this market have a look at my latest Your Daily Five video here.

Market Breadth Collapses and VIX Rallies

The divergence between the CBOE Volatility Index (VIX) and the New York Stock Exchange Advance Decline line (NYAD), described here last week was short lived and the two indices are back in synch.

Specifically, VIX made a new high and NYAD made a new low. Combined the two indicators suggest that the stock market could well be headed lower.

In fact, this is what you’d expect to see in a downtrend. That’s because a rise in VIX is a sign that put option volume (bets that the market is going to fall) are on the rise.  What follows when put volume rises is that rising put volumes cause market makers to sell puts. 

And when market makers sell puts, they have to sell stocks and stock index futures to hedge their put sales.

In other words, the market makers are accelerating the downtrend by their hedging activities which they have to undertake to preserve their account’s liquidity in a volatile market.

If there is a saving grace to the current situation, it may be that NYAD is oversold and that VIX is overbought. Thus, a reversal to the mean is to be expected.  The problem is that no one really knows when that will happen or how long it will last.

Meanwhile, the S & P 500 (SPX) reversed what seemed like a bullish end to last week and plunged to its 200-day moving average with both Accumulation Distribution (ADI) and On Balance Volume (OBV) showing the bears in charge. 

On the other hand, RSI did hit oversold as SPX traded outside its lower Bollinger Band quite aggressively. Both of these signs support the notion that a bounce is possible.

The Nasdaq 100 index (NDX) broke below its 200 day moving average. Of course, if this is not reversed, it’s a clear sign that things are about to get worse.

The S & P Small Cap 600 index (SML) also broke well below its 200 day moving average. And although it’s clearly oversold, it could move decidedly lower.

SPY Options Put Volume Was Spectacular on Friday

At one point on Friday, around 2:20 Central time on 1/21/22, just as the market broke below Dow Jones 34,400, 1/21/22, there were 440,000 puts traded at the $440 strike price. In comparison, there were only 27,000 calls. That means that the put/call ratio for that strike price was 16.29.

That’s an amazing statistic, and one which suggests that whatever happens next is going to be pretty spectacular.

So. what’s the bottom line? Get ready for more fireworks.

To get the latest up to date information on options trading, check out Options Trading for Dummies, now in its 4^th Edition – Available Now!

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Good news! I’ve made my NYAD-Complexity - Chaos charts featured on my YD5 videos, and a few more available here.

Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best selling Trading Options for Dummies, rated a TOP Options Book for 2018 by Benzinga.com - now in its third edition, The Everything Investing in your 20s and 30s and six other trading books.

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