The Market's Getting Ahead of Itself - Here's How to Profit

If you've been with us a while, my "10 Commandments of Trading" have probably helped you make easy shovel shots in all kinds of markets. My Costco Wholesale Corp. (NASDAQ: COST) recommendation this summer bagged a cool 297% profits for anyone following along.

The commandments are "rules" that are designed to turn chaos into something easily understandable. They help you make money, sure, but they'll also make you a better trader over time.

I was thinking about stocks (as I do basically all the time), and one intriguing thing stuck out: There are three of my commandments "in play" in stocks right now.

That alone tells me the tension and interplay of market forces is going to make something happen - something that could be mighty profitable if you follow my recommendation...

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Stocks Are Strengthening a Little Too Much

The 10 Commandments of Trading

I. The trend is your friend!
II. Don't run with the crowd; avoid bandwagon stocks… unless you're driving.
III. Don't pick up pennies in front of a steamroller.
IV. Cheap can always come cheaper.
V. The "smart money" rarely tells you what it's doing.
VI. Short sells are a bull's best friend…
VII. … so is volatility.
VIII. Round numbers are natural support and resistance levels – the more zeroes, the better.
IX. Stocks are driven higher by speculation, not fundamentals.
X. There's an exception to every rule.Chris will be showing you how he uses these commandments to uncover profitable trades in the coming weeks.

To be the first to hear from him, sign up to get his alerts sent straight to your inbox – completely free – here.

"The trend is your friend... until it isn't" says Commandment I. That's simply the way trends work; find one, get in the groove, pocket some cash... and then the trend turns, and it's possible for you to get hurt.

But right now, as of today, it's fair to say that we've got some friendly trends.

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The 50-day moving average (MA50) of the S&P 500 is starting to creep a little higher. The same is happening with the Dow Jones Industrial Average and the NASDAQ Composite. Until quite recently, all of these indexes were essentially trading flat; there was no real trend to be friendly.

Even the trends of the stocks in these indexes have improved, which makes sense. More than half the stocks in the S&P 500 - 264, to be precise - are trending higher. That's rather healthy.

So, with all of that said, why does it feel like the market "needs" a rest? Why is it starting to fall back a little? Is there anything to worry about if the trends are positive?

It's complicated, and it has to do with this nasty little thing called "regression to the mean."

This happens when something gets too far away from its trend. Think of it like a dog running at top speed. It's wonderful... until the dog runs out of leash. When that leash runs out, the dog yelps and gets yanked back.

That's where we are with the current market - running out of leash.

When the Indexes Hit These Levels, Watch Out

The S&P 500 is about 4.4% above its trend; the NASDAQ Composite, 4.3%. To complete the picture, the Dow hit 4.8% above a week ago, just before it started moving sideways or into a short-term correction.

The chart below displays the S&P 500 for this year with 6.5%, 4.3% and 4.4% readings marked - the readings where the market got to the end of its leash.

Historically, whenever we see the leash get stretched to 4% and beyond, it starts feeling that pull back to its trend, thus the term "regression to the mean."

You can watch for one individual number on each of these indexes to determine whether this mean regression is about to happen.

  • Dow Jones Industrial Average: 27,117
  • NASDAQ Composite: 8,212
  • S&P 500: 2,998

Commandment VIII is in play here: "Round numbers are natural support (and resistance) levels; the more zeroes, the better." Check those three levels, and let me know if you find a single zero.

A break below these levels will accelerate selling as traders realize that their old friend, the trend, has turned unfriendly - even if for just a short period of time.

That's Commandment III: "Don't pick up pennies in front of a steamroller." Don't confuse that for staying on the sidelines, though...

Here's the Play You Need to Cash In

So stocks look like they're due to come down a peg or two. Does that mean you should freak out, sell everything, and head for the hills? Not at all.

It's a sign you should stay out of the way. Use closer, tighter stops to lock in gains and head off losses on profitable positions. You might ratchet a 25% trailing stop up to 10%, say.

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That'll take care of defense - half the picture. Here's how you make some serious money while everyone else is losing out.

You can leverage even short-term pullbacks with options for far less risk and far less cost than buying a stock or - yikes - selling it short. I happen to like playing reversals in the SPDR S&P 500 ETF (NYSEArca: SPY), which tracks the S&P 500 but does so for a tenth of the cost.

SPY Aug. 16, 2019 $300 puts (SPY190816P00300000) are selling for $2.56 a contract right now (they trade in "batches" of 100 contracts), just out of the money.

These puts make a great hedge against a quick 4% to 5% drop... and a great profit play on a 4% to 5% drop that could see you up by double digits. You won't find better insurance for cheaper right now.

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About the Author

Chris Johnson (“CJ”), a seasoned equity and options analyst with nearly 30 years of experience, is celebrated for his quantitative expertise in quantifying investors’ sentiment to navigate Wall Street with a deeply rooted technical and contrarian trading style.

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