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Saturday, December 25, 2010

Use Options as Insurance for your long positions in the Bull market


The bulls will no doubt have plenty to cheer about as the Santa Claus rally puts the exclamation mark on the already impressive gains. Since July 1st, the Dow, S&P 500, and the Nasdaq Composite have seen gains of 19%, 22% and 27% respectively.
 Here's the white elephant in the room:  How much is left in the tank?

It's impossible to definitively know when we'll see a pull back, or how intense it will be. Eventually the markets will correct, but having cleared some pretty key levels of resistance, there is plenty of meat left on the bone if we go higher from here. The market has been clearly intent on finishing 2010 very strong. It's shrugging off daily downgrades of European Sovereign credit ratings, persistent high unemployment, a sluggish housing recovery, potential military conflict on the Korean Peninsula, and the tightening measures in China to slow down inflation.

Instead, the market is feeding off the very loose monetary policy employed by the Federal Reserve (QE2), the ECB's stepped up measures to buy shoddy European debt to contain the crisis, and the newly minted fiscal stimulus that was attached to the tax cut extension bill, which prompted economists to ratchet up GDP estimates for 2011.

When will the rally end?

There are many technical signs that we are potentially close to a market top. The market internals and breadth are losing their strong momentum, but still maintain a bullish advance. The price action is consolidating with tighter trading bands as the sloping pattern flattens.

Bullish sentiment hit 38-month highs, according to the latest reading from Investor's Intelligence, which polls the mood of financial advisors (many have been consistently wrong in this group)  And several days ago, the S&P 500 volatility index (VIX) -- otherwise known as the "fear" index -- closed at 15.45. That is not only below the low set from the April market top, but the lowest reading since July, 2007!

The point here is that when there is so much bullishness, that's got to be bearish. Overbought does not necessarily mean over, but the market is prime for a correction. Not only is the VIX a contrarian sentiment gauge, but it's a measurement of how expensive options are in the market place. After all, options are an insurance instrument, and when there is fear of a market decline, prices rise. When there is complacency or lack of fear, option prices deflate. With all the bullish sentiment, high equity prices, and being that the next two trading weeks will be shortened by Christmas and New Years, the price of options have been slashed like big ticket items at Best Buy!

By selling out your long stock positions and replacing them with some well placed CALL options, you can reap many benefits ...Lock in your profits, Free up your cash flow, Maintain equivalent bullish positions to capture further advances.

Protecting your portgolio and making damrt decisions about money requires strategic planning and keeping your attention focused on all the proper strategies available to you.