December 13th, 2022

Why CPI Numbers May Not Bring The Rally People Expect

The market took off on Monday in anticipation of the CPI numbers, but here’s why I’m still concerned about bearish momentum.

The market finished up some 500 points on Monday but look at some of the numbers in the chart below. This table shows how many new highs were made in different time frames vs new lows. I can understand the argument for not seeing many new 52-week highs considering where the market was this time last year, but with the market up over 500 points yesterday, why are the companies making new 1-month lows outnumbering the new 1-month highs by 3:1?

You can read this with a contrarian view and say the market is bound to head higher from here with so many depressed stocks over multiple timeframes or you can be concerned that yesterday was more about short covering before a week of news and the overall direction is still heading down.

Investors are trading on future expectations of a 2023 recession as more companies are planning layoffs in the new year. That’s why I think you see more companies hitting new lows, even though we’ve received news these past weeks about inflation peaking.

Another reason I’m hesitant about this market is this chart. Here’s a weekly chart of the SPY and you can see a wedge formation. The last green bar only has yesterday’s data, but if the week closes lower and breaks the wedge to the downside, my price target is $381. If the market is going to break the wedge to the upside, I’m looking at $412 before we hit resistance.

Is there a way we can trade using this information? Assuming you agree and are bearish and also believe that the market isn’t likely to move above $412 in the next month and a half, I have a potential trade we can review for education purposes.

Here’s a trade idea based on the premise that SPY won’t go above $412 by 20 JAN 23.

Sell to open 20 JAN 23 $412 call
Buy to open 20 JAN 23 $420 call
Sell to open 20 JAN 23 $412 put
Buy to open 20 JAN 23 $410 put
Net credit: $3.66 (buying power effect -$434.00)

You can see that you have unlimited downside potential and the breakeven of the trade is about $415, which is $3 higher than the price I mentioned above.

My profit target is 80% of the lower line, which would mean $132 in profit. The max loss to the upside occurs above $420 and that would result in a $434 loss.

The profit target of $132 divided by the max loss of $434 equals about a 30% return on risk.

A trade like this gives you room to be wrong should the SPY move higher, and it has no downside risk. This trade also benefits from the time decay of the sold options so even if the SPY moves higher, it can still end up being a profitable trade over time as long as it doesn’t go up too much and too fast.

Let’s say you set up a mental stop that you’ll get out of the trade if the SPY hits $412, the most you’d lose is about $122 and that’s if the SPY went up to $412 tomorrow. With a profit target of $132 and a mental stop of $122, you now have a slightly better than 1:1 reward-to-risk trade if you’re bearish on the market.

Please note, this trade was set up using pre-market prices and may not reflect the actual prices of the SPY. This is for educational purposes only.

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Jeff Wood

Editor, Filthy Rich Dirt Poor

Trader, Options Testing Lab