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Market Drop Could Be Deep and Swift [Here’s How To Trade It]

Posted by Pete Stolcers on January 27

Posted 9:30 AM – This morning the S&P 500 is down 50 points before the open and the Coronavirus is sparking fear. Bullish speculators are about to get flushed out and the first wave of selling could be deep and swift. Bullish sentiment is near all-time highs and Asset Managers are not hedged. From a trading standpoint, we need to let the market drop and we need to wait for signs of support. This morning first support is at SPY $325 and it will be tested. The next decent support level is at $320.

The Coronavirus spreading at a rapid pace and the new cases are growing at a pace of about 50% per day. On the first lunar day of the Chinese New Year, air travel is down 42%, rail travel is down 41% and road travel is down 25%. China is trying to get ahead of this crisis. The death toll currently stands at 80. Disney Shanghai is closed and Starbucks is closing many of its locations. This will have a temporary economic impact.

There were explosions in Iraq that injured three people in the US Embassy. From a market standpoint, this won’t have much of an impact.

The economic data points this week include durable goods orders, GDP and Chicago PMI. China will also post its official PMI on Friday and that will be the most significant economic data point this week.

Earnings season will kick into high gear and we will see if mega cap tech stocks still have some gas in the tank at the upper end of their valuation range. On Tuesday, Apple, Advanced Micro Devices, eBay and Starbucks will report. On Wednesday, Boeing, Facebook, Microsoft and Tesla will report. On Thursday Amazon will report. These reactions will be critically important. Apple, Amazon, Google, Facebook and Microsoft account for 18% of the S&P 500. As they go, so goes the market.

Wednesday the FOMC statement will be released. The Fed has been very accommodative and I’m expecting them to reference the economic impact of the Coronavirus and that they will be ready to ease if needed. I don’t expect a knee-jerk reaction in the early stages of this outbreak.

Swing traders should largely be in cash with only 25% exposure on bullish put spreads. We have been waiting for a market pullback and we are getting one now. We were also waiting for post earnings release plays and this is the first week when they really start to crack up. I’ve been suggesting a hedge using VXX if you have a lot of exposure on bullish put spreads. If your stocks are staying above technical support and you still have small profits, take them. Reduce your risk and let’s see how far the market comes in. Ultimately, this will be a fantastic opportunity to sell out of the money bullish put spreads. We need to be prudent and wait for the selling pressure to decelerate. We need to gauge the impact of the Coronavirus. We also need gauge earnings reactions and guidance. Each day this week we will gain much needed clarity. Have your wish list ready and monitor stocks with relative strength. There are going to be many opportunities in the next two weeks and they will set us up the entire quarter.
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HERE’S A VIDEO ON HOW TO TRADE THE CORONAVIRUS – POSTED THIS MORNING – CLICK TO WATCH
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Day traders should let the market come in. I feel that the initial drop maybe overdone, but you never know. The only thing I might do in the first hour is to sell my SPY put options. I bought the SPY Jan (31) $330 puts Friday and I took profits on half of the position before the close. I still have the other half and I will look for an exit point this morning. If I start to see long tails underbody at a specific support level I will take profits knowing that a bounce is coming. These options will expire Friday and they are susceptible to time decay and a decline in implied volatility. IVs will spike this morning and my puts will benefit from that. My VXX position will also benefit. When bullish sentiment is this high and when traders have been selling option premium (VIX near historic lows) there is a chance for a deep and swift market drop and that will be fueled by institutional sell programs. Consecutive long red candles closing on their low early in the day would be a very bearish sign and if this materializes it would mean that we are going to go down the entire day. If we see consecutive long green candles closing on their high early in the day probably we are going to find support and rally into the gap. Look for long tails underbody. I am expecting a very early washout and support to form in the next few days.

Don’t be overly aggressive with longs yet. This could be a nasty washout and the Coronavirus will get worse, not better. We also don’t know if mega cap tech stocks are able to rally after earnings. The most prudent thing to do for swing trades is to wait on the sidelines for a few days. We will have clarity and that we will be able to strike with confidence.

Good luck today.
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