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Volatility, The EU mess and a US Double Dip Recession.

With all the concerns around the world: the EU’s mess, lack of jobs in the US, poor housing market numbers and the threat of a double dip recession, what can I do???

A student recently sent me the following question:

“So I have 7 open positions in my paper trade account, all of them are either collars, or have been adjusted to collars. Question is, if you would close such trades at such times? Or did you only close spread trades last week due to the high uncertainty of the market. I am considering what is better to do, take profit on the profitable ones, and close everything (about 3% loss on the portfolio) or keep managing the collar, and maybe even turn some of the most bearish ones to ratio backspreads, to create a negative NPD and profit on the downside.”

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Your question really centers on your expectation for the markets over the next couple of months. If you feel that the markets are going to move lower, then remaining in collars or simply closing positions and going to cash makes the most sense. Playing this market closely is extremely difficult as the moves in the market place over the past three weeks have been +/- 1.5 to 6.5% on a DAILY basis! So how does one make any real sense of that and how does one position their portfolio? For me, I’m still WAY away from the ATM position and am watching the headlines to assist me in my own expectation. My expectation, by the way, isn’t all that good. Here’s what I see coming… A major banking institution in the Euro zone is going to fail. The paper assets (bonds, notes etc…) that they are holding are losing value fast and the reserves are already much too low. When word of this gets out, there will be a run on that bank and others in the Euro zone. This will have a domino effect as they are all very low on reserves at this time. Taking all that cash out will put the banks below reserve requirements and force them to liquidate anything they can. When that happens, prices fall sharply as no one is interested in buying so the prices just go lower, and lower, and lower… Meanwhile, other banks will refuse to lend to the stressed banks for fear of losing their own reserves. This will freeze up the credit markets all over the world (sound familiar?) and WILL have a dramatic effect on the markets of all nations. So that’s the danger in the Euro zone. What about here in the United States?

I suspect that here in the US, we are already in a recession, we’re just waiting for the “official” word to confirm it. All of the economic reports suggest a dramatic slowing of activity, and just this past week the Philly Fed and the NY Empire Manufacturing survey indicated contraction… Housing numbers were lousy and jobs are still nowhere to be found. Fear is rampant and the consumer (the one who truly drives our economic engine), is hearing nightly of all of the worlds troubles and a “double dip” recession. No wonder that the consumer is opting to save rather than spend. The big recession of ’08 – ’09 is still very fresh in everyone’s minds. We need look no further than the most recent GDP numbers and the revisions to Q1 and Q2. All of it downward. There will be some very important news this week; GDP data on Friday, and, perhaps even more importantly, Ben Bernanke’s speech from Jackson Hole Wyoming, also on Friday. Wow, with all of this going on, how can I trade at all?

The strategies that I am employing at this point are theta based. I am collecting premium while making small adjustments to maintain a “delta neutral” position. I am prepared to adjust that into a more bearish position should these horrible events that I am expecting actually come to pass. For now, we are going to continue to have big up days and big down days. Trading directionally at this point simply makes no sense to me.

If you feel a strong level of uncertainty as to the market’s direction, then simply waiting makes a lot of sense. Never forget, protection of principle is job one…

Jeff McAllister
OptionsANIMAL Instructor

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