The market had moved into a short-term overbought state, excessive optimism had pushed into the market and seasonality had entered a historically bearish.

And over the past several weeks all of the aforementioned have pushed further and further into a bearish state.

But, the bulls have yet to waver and the grind continues. Since December 19th the S&P 500 (SPY) has climbed over 12% without pause.

However, as we all know this is how it works, the market grinds higher and crashes lower. It’s like stacking pennies and now the stack has reached 50 pennies high and it’s teetering.

I am not calling for a crash. But let’s be real. The market can’t sustain this push. Of course, this rally could be an anomaly and the market pushes even higher over the next few months. Why not? 20% in two months? I think we all know what the probability of that type of move is and the  percentage isn’t high. And remember, it’s all about the probabilities.

Interestingly enough it brings back a Wall Street adage that has stuck with me since the beginning of my trading career.

“If a stock makes a large move (over 10%) in a single month period, the odds are greater than 2 to 1 that it will move in the opposite direction in the next monthly period.”

Will this be the case in February for the major market indices? There is no doubt that the risk is to the upside. I think we all know we could easily see $127.50 in a matter of days on the S&P. It doesn’t take long, once the selling begins particularly when the conviction to the upside has been lacking as seen by the low volume advance.

Just more food for thought.

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The Nonfarm Payroll report is often a market mover and I expect to see much of the same tomorrow.

The market is wound tight and typically when that occurs we are witness to a large directional move.

I expect, regardless of how positive (or negative) the report is tomorrow, the market will push lower.

As most of my loyal readers know (and thank you all for the amazing support by the way) there has not been a shortage of bearish indicators as of late. Over the past two weeks, with volatility drying up (VIX now in the low 18’s) due to the tight trading range over the past two weeks, bearish indicators have piled up and have reached extreme proportions. I compare it to stacking pennies, eventually the stack falls when the weight becomes to great. And right now, the weight of the market overwhelming.

But back to the Nonfarm Payroll report.

Talented analyst Jason Goepfert of Sentimentrader.com recently stated that when “the S&P 500 closed at a six-month high with volume 10% off its low from the past month (as it did on Thursday), then the next two days were positive only 12 out of 46 times.”

Out of the 12 positive occurrences, only twice did it advance more than 1%. Thirteen times it closed with a loss greater than 1%.

Another interesting stat provided by Mr. Goepfert is “the last 8 Fridays when the Nonfarm Payroll report was released” all have closed lower than than te prior trading day.

In fact, if you went back to September 2009 and purchased shares of the S&P and sold at the close of the trading day you would have only made a paltry 1%.

Couple the aforementioned studies with short-term overbought readings in three out of the four major indices and I expect to see a short-term pullback over the next 1-5 days.

The two best performing days (on a historical basis) in February are now behind us and now we are entering into a period of bearish seasonality.

Just more food for thought.

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It’s perseverance frustrated bears.

The infrequent single day declines maxed out at -0.6%.

And the last nine days of the month were more than mind-numbing for most traders as the market traded in a very tight range.

There’s no doubt the bears are ready. Almost every technical and sentiment measure I follow has pushed into a bearish state. Typically, I am ecstatic by the weight of the bearish measures, but it seems everyone is aware of the measures and have joined my camp. And when what seems like the herd is anticipating something it has a hard time coming to fruition.

We must remember that January is one of the strongest month of the year for the market. February not so strong with a historical return of 0.0%.

February swoon?

After three months of gains a decline seems the likely scenario. Again, almost all technical and sentiment measures have reached short to intermediate-term extremes, but will they win out for the bears or will the mighty power of the bulls push through the consolidation that has lasted nine long trading days?

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Hacks, hacks and more hacks?

I hate to say this about some of my fellow options traders, but I can’t tell you how much I abhor those in the industry (you know who you are) that absolutely ruin the true benefits of options for the self-directed investor. Claims of outlandish 300%, 400%, 500% in just a few days. Encouraging the use of low-probability out-of-the-money puts as a predominant strategy without the mention of selling premium.

It’s frustrating.

It’s frustrating to see so many so-called gurus with no real-world experience act as options traders when their services fail time and time again. Again frustrating.

Why don’t people want what’s important, realistic gains with realistic strategies. Transparency. Knowing that trading isn’t easy and is a life-long endeavor and that while the journey may be bumpy at times over the long haul it is worth all of the effort. A long-term approach to short-intermediate-term trading with high-probability trades as its foundation. Selling credit at every extreme and occasionally taking some greater risk with a few directional plays. Always talking about the importance of position-sizing. Always considering risk-management.

Why would people rather join services that tout such outlandish claims? It is beyond me. Are self-directed investors really that gullible?

It is my hope that I have carved and will continue to carve a slice of decency and transparency into the options world. I am certainly not perfect, but I know that options are a valuable tool for every investor and it is my goal to teach as many people as I can about the benefits they offer.

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Check out the article - All it Takes is One Bad Trade

For those of you who have not been reading my posts the past several weeks, I have been reminding my loyal readers of the following:

For several weeks I have warned of the following: The Rally That Never Stops, Up, Up and Away, Not if History Has a Say and How to Recognize a Bear Market Rally

Don’t Be a Hero When Trading Options

Options trading seems to create a “get rick quick mentality” that attracts the “speculative gamblers” out there. To me this approach seems short-sighted, unless that is your goal and you are willing to take the risk. I prefer to take the “long-term” approach that attempts to beat the market over an extended period of time. Admittingly, I “go for the gold” sometimes and place a highly speculative trade. But those are few and far between and I would never allocate a large portion of my portfolio to a trade like this. It is just too risky for my blood after what I have experienced as a trader. Take the loss and move on. Think in terms of probablities. Use a scientific approach. Losses are a cost of doing business. It is how your account compares to the benchmarks after a long-period of time that defines your success. Any Joe options trader can make a bundle on a trade. It is how Joe performs over the long-term that defines his success.

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If you were not privy to the stats that I  provided last week by the wonderful sentiment analyst Jason Goepfert of Sentimentrader.com here you go:

Starting around the 2nd week in January, stocks have had a consistent tendency to weaken.  Or at least not show much strength.  Especially technology.

I don’t want to hammer on this too much.  Seasonality is a tertiary indicator at best, and can easily be overwhelmed by fundamental developments, technical breakouts and changes in sentiment.

The performance of various sectors since the day honoring Martin Luther King, Jr. became an exchange holiday in 1998.  The performance of QQQ was positive only 1 out of 11 years into the end of the month.

He goes onto to provide a wonderful chart that shows sector performance after the MLK holiday and the Nasdaq 100 only has a 9%, yes 9% chance of closing higher than its price level before the holiday.

Furthermore, 24 of the indicators he follows are reading bearish, not a single one is bullish. Some of the indicators include Rydex Bull/Bear RSI Spread, Put/Call Ratio – OEX Open Interest Ratio, every Put/Call RAtio including Equity Only, Total of All Options, Equity Moving Averages, Liquidity Premium QQQ and SPY, AAII Sentiment Survey and the list goes on and on. So, I think you get the picture.

1/3 gap here we come?

Okay, so if the post-MLK meltdown is to occur we would need to see a move down below $58.18 or 2.7% in the Nasdaq 100 (QQQ) over the next six days.

We are still in the weakest period of January, but even that is coming to a close over the next few days.

Courtesy of Sentimentrader.com

And there are a few catalysts that could certainly help to bring this market lower over the next few days.

• Apple earnings due out tomorrow after close (1/24)
• For the first time ever, the Fed on Wednesday will release forecasts for the path of interest rates.
• GDP release Friday

It just feels as though the market is teetering. I get the sense that the bears are just waiting for the bulls to pile on in drives before we see what will be a fairly decent decline that closes the 1/3 gap. One thing is certain, we are in the most short-term overbought state that I have seen in years, so something has to give. Grinds higher typically lead to collapses lower. The problem is knowing when the grind ends. I think the time is near.

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Bottom line – stock investors/traders are truly at a disadvantage.

Again, stock investors only have two ways to make a profit: buy a stock or short a stock. And most retail investors are not willing to short a stock, so basically they are only able to profit in one direction – up.

Another characteristic that stocks have is that they don’t have an expiration date like options. I know some of you are probably rolling your eyes right now. How could something that expires be more attractive than something that can be held to perpetuity?

Well, we all know about the marriage that many of us have for our beloved stock positions. A plan to end the investment/trade often doesn’t exist because the stock goes up and you hold it and then it goes down and you hold it even longer and if it continues to go down you hold it for that much longer hoping that your position will eventually come back to break-even and even then most decide to exit the position.

Just think of all the missed opportunities. It drives me absolutely insane to think about it. Your capital could have been used for so many other opportunities. Also, an expiration date forces options traders to truly think about the risk/reward of each and every investment /trade. Furthermore, it forces the options trader to think about the future in greater detail.

Remember, when you buy a stock, you have the entire amount of your capital at risk and more importantly you have dedicated a large portion of capital to the trade. With certain option strategies you could have a tenth of the capital tied up with the same risk.

Of course, there will always be the foolish guy who has dedicated as much on one options position as they would in a stock position., They don’t understand the importance of position-sizing. And position-sizing is THE key to being successful trading – PERIOD.

A basic rule that I like to use is that if I become too emotional about a losing trade then I have too big of a position on.

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But, I am not completely sold on the rally yet.

Why? Well, other than the overbought to very overbought readings in most of the ETFs I follow and all of the reasons mentioned in my post yesterday, we are also entering into the weakest period of the month of January. Just look at the DIA chart below for percentage of times positive over the next five trading days.

courtesy of Sentimentrader.com (click to enlarge)

If you look at the ETFs I follow in the High-Probability, Mean-Reversion Indicator you can see that almost every ETF I follow is in a short-term extreme. Extremes that have not been seen in quite some time. I can’t remember the last time I saw all four major market benchmarks in a very overbought state. The decline is coming and soon. The question is how long will it last? Will it be long enough to close the gap from 1/3 or will it be a another one hit wonder. We shall all see soon enough.

I also came across an interesting article written by James Kostohryz wrote on Seeking Alpha which mentions three handy tools for investors to identify the characteristics of a bear market rally so as not to be lured into one. Interesting reading indeed.

How to Recognize a Bear Market Rally

1. Fundamentals: The first challenge in determining if a rally is legitimate or not is to address the fundamentals of the bear market. Are they still in play? “Stocks will often rally on relatively insignificant news during a bear market rally – news that in no way negate causes of the original decline. However, in a bear market rally, fundamental deterioration continues beneath the surface despite rising stock prices.”

Given that troubles in Europe helped spark the market decline, we can say these fears still hold. In fact, the likelihood of an economic collapse in Europe seems more likely today than it did on October 4th. The same can be said of America’s political and budget-cutting issues.

2. Low Volume Advances: “Bear market rallies are characterized by extremely sharp advances on relatively low volume. Such advances are driven by price-indifferent purchases by short sellers, put buyers and call sellers that are aggressively executing stop-loss orders,” writes Kostohryz. “Furthermore, in bear market rallies the sharpness of the price increases indicate price indifference on the part of long investors.”

With regard to this element, market actions since October 4th have been sharp and on low volume.

3. Sentiment: Rallies are fueled by a reversal of pessimism and skepticism, explains Kostohryz. “Extremely bullish sentiment suggests a high probability that reasonably foreseeable positive factors are already almost entirely discounted in the price of stocks.”

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That’s a question I often receive. My typical response, I don’t care. Okay, that may be a bit harsh, but it is true. For the most part I really don’t care about the daily news that flows in and out of the market. I am an options trader. I trade strategies based off probabilities. I create statistical advantages based on my current market assumptions.

We must realize that knowing what is going on in the news and knowing how to make money consistently are two separate things. For successful options investors it’s about your strategy, your logic, your process, it doesn’t matter what you think the market the latest economic report is going to say. I realize it’s a difficult concept for the options newbie to understand.

You see, it doesn’t pay for me to try and absorb every financial story out there. All I care about is when my indicators hit extremes. I allow probabilities, not the talking heads, to define my options strategies.

And this means that the strategy enters periods of stagnation. Trades should never be forced. A forced trade is not a statistically sound trade. Again, this market apathy is a long-term approach to options trading and should be expected if you wish to bring in profits over the long-term.

Boring? Maybe to the aggressive crowd out there. But, I am more interested in the profitable trades – not trying to be the short-term hero who trades every scenario out there. I am confident in trades that consist of short-term extremes that have entered the stock market – high-probability trades.

What is a high probability trade?

The High-Probability strategy is a short-term directional strategy that utilizes single calls and puts based on overbought/oversold extremes in the market. The strategy requires patience coupled with a disciplined approach. The strategy consists of approximately 2 to 5 trades a month with holding periods of 1 to 10 days, however; there will be some months when I make no trades..

Again, the key to this strategy is patience. Waiting for the appropriate scenario to trade with a high probability of success is what makes this strategy a success.  As I always say, opportunities are made up easier than losses. So if you let a few pass you by don’t dwell on what could have been. There will always be more opportunities around the corner. Remember, trading is a marathon not a sprint.

What About The Markets Right Now?

Just look at how many overbought to very overbought ETFs are in the market and you can quickly see why I expect to see a short-term reprieve over the next week. Typically, when we see a reading like the one we have now in most of the ETFs I follow a short-term pullback is to be expected. I already have a few positions on in both of my options strategies, but I am not hesitating to add more if the market tells me to do so. All I can do is trade probabilities as it is all we have as traders. If we gap up again tomorrow, I will most likely fade, fade fade. Remember, position-sizing is the key to long-term trading success so keep your size small and never trade too big. Trading too big will ultimately lead to failure.

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As I suspected – he uses options irresponsibly in his service - as most people do. And I told him so.

His response – “You sound like an idealist.”

An idealist? Why? Because I do not allow marketing efforts to control my options strategies? Because I do not gamble with options by attempting to guess which way an earnings call will go? Because I do not buy out-of-the-money options in hopes that an option will move towards my chosen strike price?

I could go on and on.

I was amazed how little he knew about how to effectively trade options. He actually asked me about how I used statistics to gain an advantage in my trading. This man has been in the industry as an editor for several major newsletter publications for nearly 15 years. 15 YEARS!

And yet, he doesn’t know how to create a trade with a probability of success of your choice – be it 70%, 80% or 90% chance of success.

He stated that using credit spreads does not work for the retail public. It doesn’t sell. It’s too complicated.

I could not believe what I was hearing. This man, who had no clue about the true advantages of credit spreads (like in our Theta Driver Options Strategy).

The general consensus in this business is that the the public is too stupid to place a credit spread. He told me that his marketing department told him not to use credit spreads in their options services.

Why? Because according to him, lots of lottery-ticket gambles are more attractive to readers – and they help create a portfolio of huge winners. He didn’t mention that it also creates lots of big losses. And it might be that it’s easier to sell a newsletter when you can promise lots of chances for big gains.

But that is not my goal as the editor of an options service. I want to educate anyone willing to listen how to effectively trade options like the professionals do. And that does not mean creating more complicated strategies – it means keeping them as simple as possible.

I do not tout outlandish gains. I only try to bring to you the best strategies that I know.

The strategies that floor traders use.

The strategies that create real statistical advantages.

And then I try to incorporate risk-management techniques as well. He actually scoffed at that as well.

If you want an options strategy with a gambling mentality then you certainly have your pick. There are probably dozens of them in your email inbox right now. But I am not a gambler and therefore I do not offer daily trades with no statistical advantages.

I am a realist. I realize there is no holy grail in trading. However, one thing I do know for certain is that I have found several unique and concrete strategies that make a world of sense to me and I trade them to make serious money over the long-term. Furthermore, I realize that the less I trade, the better my strategies will perform over the long run: And the long run is what matters. This is what makes my strategies unique and so far, successful.

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