ETFs May Be Setting Up For A Technical Bounce (QQQQ, DIA, SPY, XLF)

Good morning traders, I wanted to take a minute and give you my thoughts on the market. Overall I was very satisfied with Friday’s price action and I strongly believe NOW the market is due for a rally. Below you will see some charts, which will support my belief.

First up, we’ll take a look at the PowerShares QQQ ETF (NASDAQ:QQQQ). The candle pattern here is what is known as a piercing pattern and usually signals a bullish reversal. Some key things to note on this chart are: volume on Friday took out the volume Thursday, and the (QQQQ) ended up closing back above the 200 day moving average.

Click chart to enlarge

Next up is the Dow Jones Industrial Average SPDR ETF (NYSE:DIA). This chart is almost identical to that of the Q’s as it formed the same bullish candle pattern, volume Friday took out Thursday’s, and it closed above its 200 day moving average. However another thing to note is that the DIA traded within a quarter of the “Flash Crash” lows before bouncing.

Click chart to enlarge

Now for the last of the major index ETF’s, the S&P 500 SPDR (NYSE:SPY). As with the other two index ETF’s outlined above, this also formed the same bullish piercing pattern, however it did not take out the previous days volume nor could it close above the 200 day moving average. One very interesting thing to note is that the ETF bounced after touching the February closing lows. You can see this on the chart with the Fibonacci retracement lines drawn in blue. We can see the ETF retraced 100% of the move from February 8 close to April 28 close and bounced off of the lowest line.

Click chart to enlarge

It’s also important to note that I also believe volatility will come in (or trade lower). To most investor’s or trader’s it is common sense that as the market rallies, fear or volatility trades lower – which is true. So, the chart below of the volatility index [VIX] will also help support my belief. Unlike those bullish piercing patterns on the ETF’s outlined above, the candle pattern which has emerged on the Volatility Index [VIX] is a very bearish pattern. The candle pattern which has emerged on this chart is what is known as a bearish engulfing.

Click chart to enlarge

How I’m playing this potential reversal
After looking at hundreds of charts over the weekend, I put together an option strategy using the Financial Select Sector SPDR (NYSE:XLF). I chose the (XLF) for two reasons, the main reason being that the (XLF) formed the most bullish chart pattern of the major SPDR ETF’s I analyzed, and the other reason being that implied volatility is highest in this ETF and if overall market volatility decreases as I expect it to, this should greatly benefit my strategy, as I will be net short volatility. Before you read the strategy outlined below you will need to have knowledge of stock options. To learn more about the option strategies outlined in this post, risks, pricing, calculations, other strategies, and options in general, check out my e-books here.

Click chart to enlarge

XLF Option Strategy:
Using the September options expiration, I am looking at selling 14 strike put options for a credit of $115 per contract (meaning I receive $115 cash for each contract sold), with the premium received I will then look to open September vertical call spreads by purchasing September 16 call options and selling September 17 call options against them (one for one) for around $35 per call spread. Note I am choosing to sell the September 17 calls only because volatility is so high and I do not want to overpay for call option premiums. However if one is very bullish a higher strike call could be sold or none at all. Based on theoretical prices as of market close Friday May 21, 2010 this entire strategy can be filled for a net credit of $80.

Profit & Loss: My maximum loss using current data is $1320 per custom spread, and that is if the (XLF) trades and closes on September options expiration at 0 [zero] per share, highly unlikely. This strategy will return the net credit of $80 if shares of the (XLF) close above 14 but below 16 come September options expiration. If the ETF trades higher and come September options expiration shares of the (XLF) are at or above 17, the call side of this strategy will return an additional $65 or 186% (less commissions). This strategy will break even as long as the (XLF) closes and expires above 13.20 per share on September options expiration.

The ideas outlined above are bullish strategies and should not be considered if you think the ETF will sell off in the near future. However if you feel the ETF could move higher in the near future, this strategy could yield a nice gain. Selling puts “naked” is a very risky strategy and should not be considered with stocks one does not plan or want to hold long in their portfolio. To get a better understanding of stock options and different option strategies please check out my Simplified Stock Option Trading E-Books.

These are just examples and are not recommendations to buy or sell any security; if you’re more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last five years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

I must state that one thing which makes me skeptical of a coming rally is the fact that so many individual stocks and ETF’s have such OBVIOUS bullish potential reversal chart patterns. And as many of you know, the more obvious they are, the less likely they are to work. Also, it is very important to note before I get into the option position outlined above I need to see a follow through of Friday’s action. From a technical standpoint I believe we are due for a bounce, however as we all know anything can happen… Happy trading.

Written By Marco Anthony From Option Maestro

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