If you missed it Wednesday morning, I talked about how my “Walk Down Main Street” approach has pinpointed the iShares Russell 2000 ETF (IWM) and its constituent stocks as one of the most critical segments of the market at this moment. Here’s why…
The small-cap sector is the heart of the market. Sure, large-cap tech stocks and the “too big to fail banks” have a reputation for being the market, but the small-cap stocks are the up-and-comers – the real worker bees of the market.
They’re also the more speculative side of the market, and if you know me, you know that’s incredibly important, because of one of my Ten Commandments of Trading is:
“Stocks are driven higher by speculation, not fundamentals.”
What I mean by that is, bull markets are driven by investor speculation that prices will go higher. If you lose that speculative driver, the market is more likely to go down, as investors will just find a safe place to put their money until they feel they can speculate on higher prices again.
Now, with that knowledge, a simple look at whether the small-cap IWM is leading or lagging the S&P 500 will answer the simple question of “Are we in a bull market?” based on whether investors are speculating on higher prices. Here’s your answer.
As you can see, the relative strength of IWM has broken down since the beginning of the regional bank crisis, as traders and investors have re-assessed their risk appetite. That drop in risk-taking puts additional pressure on the market as we head into the seasonally weak post-earnings period.
Knowing that the retail and regional bank stocks make for a good weighting of the small-cap universe puts these two economically sensitive groups near the top of my bear market watchlist.
As always, I’m looking for a driver for my trades, and I needn’t look further than my Bollinger Band Squeeze filter.
As of Wednesday, there were 767 companies flashing early signs of upcoming increases in volatility – what I call “volatility storms.” The majority of these are trending lower, indicating volatility is likely to take the markets lower. Here’s a short list of the companies within the small-cap universe meeting this criteria.
While my current focus remains strong on the regional banks and weakness in the consumer discretionary and retail sectors, there are a few companies that fit my current outlook for both a new bearish trend in the markets and a rapid increase in volatility. I’ve identified them in the list above with red shading.
Two of these companies stand out more than the others: Spirit Airlines Inc (SAVE) and Guess Inc (GES).
Let’s take a quick look at the drivers of these trades.
Guess is a semi-luxury apparel company that makes everything from handbags to jeans. From a fundamental perspective, the company has been lagging behind the market on earnings. They’ve seen shrinking revenue result in their earnings missing expectations in three out of the last four quarters.
The poor fundamentals show in the technicals, as the stock is trading in a bearish trend – as indicated by the declining 50-day moving average (MA50). Putting the stock in additional technical danger is the fact that GES shares just broke back below their 200-day moving average (MA200). This combination forecasts lower prices for GES stock.
I mentioned my Volatility Squeeze filter. The current readings of my indicator are at 8.3% after hitting a low of 0.3% just four trading days ago. This means the stock is likely facing a sudden increase in volatility.
That volatility acceleration is going to be triggered by a break below the stock’s $18 price level, which after being broken will open a technical trading pathway to my current short-term target of $15.50. That represents a 15% decline in the stock at the hands of a large increase in the volatility of the stock price. A trader’s dream.
Here’s how I’m trading this technical situation…
While I could short the shares and collect a 12-15% decline, I would have to do so using margin on my account. Given the risks that the market could see a short-term rally, I prefer to keep my margin balance out of the trade and instead use a put option to capture my gains.
The June 16, 2023 $18 puts are currently trading for $1.10. With my target price of $15.50, that put would capture $2.50 in intrinsic value, which at minimum would more than double my original trade amount of $1.10.
Should the volatility happen much sooner than the June expiration, this option will still have time premium remaining, which will increase my profit potential on the trade.
Here’s the exact trade recommendation I’m following.
Buy-to-open the GES June, 16 2023 $18.00 Puts using a limit prices of $1.10 or better
May 03 2023