Trading the NASDAQ Bust 2

By: Adam Hamilton | Fri, Jan 3, 2003
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Well, 2003 is here and it is time to get to work! Just as last year, vast riches lie ahead in the murky mists of time just waiting for intrepid speculators to come and stake claims on them.

Some speculators will be blessed with truly legendary profits in 2003, while others will watch in horror as the Great Bear continues to eviscerate their trading capital. Our mission as speculators this year is to study hard and work even harder to increase the probability of ending the New Year in the winners' circle.

The fascinating art of speculation surely must be the grandest of strategy games, like a 4-dimensional chess match played against the best and brightest on Earth. Just as with anything else in life, the more you speculate the better you will become at speculation. With every new round-trip trade you make your knowledge, experience, and prowess in the art of speculation will grow.

We were extremely blessed to experience this wonderful natural progression at Zeal last year. The great game of speculation remains the same, but with another year of age and wisdom under our belts our speculation methodologies are growing in sophistication and probability of success. It is exhilarating learning this art and playing the game, as one could spend a dozen lifetimes studying it and still barely scratch the surface.

Last February I wrote the ancestor of this essay, "Trading the NASDAQ Bust". The core thesis involved using simple technical trendlines to trade the supercycle Great Bear market. If the NASDAQ's lower support line was hit, as after 9/11, speculators needed to throw long. If the NASDAQ's upper resistance line was hit, as in early 2002, speculators needed to throw short.

The ideas were simple, but praise God they worked! When the essay was published on February 22nd, 2002, the NASDAQ closed at 1725. At that time, just like today, the usual Wall Street perma-bulls brazenly proclaimed that the post-9/11 low of 1423 was certainly the ultimate bottom and the end of the Great Bear. As always, Wall Street's only mission in life was to sell optimism to the gullible public. Never forget that Wall Street will always be bullish on stocks until The End of the World!

In the essay I dared utter heretical words that earned me a blistering phalanx of hate mail from the perma-bulls. I said, "After bouncing off its top resistance line in early January, the evolving NASDAQ bust is conforming perfectly to a declining bear market sine wave and is heading back south. It will probably slam into and bounce off of the bottom support trendline sometime in the next couple months, probably around an index level of 1100 or so."

While that brutal NASDAQ downleg did unfold a bit slower than the technicals at the time suggested, the NASDAQ did indeed bounce off "1100 or so" at its next interim bottom. On the dark day of October 9th, 2002, the NASDAQ closed at 1114, down 35% from when the original "Trading the NASDAQ Bust" essay was published.

At Zeal we are zealous speculators and constantly trade off our own research, so we purchased QQQ puts and recommended the same to our subscribers in our February Zeal Intelligence newsletter. We were very blessed to be able to sell the QQQ puts based off of this simple technical analysis for a 350% realized profit for our subscribers in early August.

This year, we are once again actively trading the QQQ options to play the NASDAQ bust and have dramatically refined our strategy. Rather than using simple chart lines to attempt to time entries and exits, we are now using exogenous technical indicators to grant us a powerful proxy on the general greed and fear perpetually swirling around the NASDAQ.

As every contrarian speculator knows, the whole game is to buy on fear and sell on greed. When the thundering herd is terrified and drenched in fear, prices are low and it is time to go long. When the masses are complacently lusting after exponential price increases into infinity, greed has set in and high prices mandate a prudent speculator throw short.

I briefly mentioned our new NASDAQ bust trading strategy in "Trading the Put/Call Ratio" and our Zeal Intelligence subscribers have already had a fantastic opportunity to lay up some carefully-targeted QQQ options positions that could prove to be immensely profitable sometime in the first half of 2003. We called the opportunity "The Big Trade" and laid the foundational groundwork for it over several newsletters last year.

Our new NASDAQ bust trading strategy is not complicated. It merely involves marrying the 21-day moving average of the CBOE Put/Call Ratio together with the venerable VIX S&P 100 Implied Volatility Index to better time the brutal NASDAQ downlegs and subsequent spectacular bear-market rallies. Using these powerful unrelated general sentiment proxies in tandem as a binary exogenous indicator for turning points in the NASDAQ and QQQs has enormous potential.

If the previous paragraph seems as incoherent and meaningless to you as Alan Greenspan's endless indecipherable babblings, you may wish to skim a few essays to digest the necessary background information to get up to speed. I recommend "Trading the Put/Call Ratio", "Volatility Trading the QQQs 2", and "QQQ Options Trading 101" as necessary prerequisites for understanding and implementing our new NASDAQ bust trading strategy.

How to trade the ongoing NASDAQ bust in 2003? We are going to use the PCR 21dma as our short signal and the VIX as our long signal!

Lunacy? Perhaps. Neither the Put/Call Ratio nor VIX has any direct relationship with the NASDAQ Composite or QQQs, but both exogenous technical tools seem to have a fabulous recent track record of flagging unsustainable sentiment lows and highs at key NASDAQ turning points.

The PCR 21dma marks greedy topping points with astounding precision and the VIX flags fear-laden bounce points with phenomenal accuracy. On low PCR 21dmas, short the QQQs, sell your QQQ calls, and load up on QQQ puts. Then relax and take a multi-month vacation from worrying about daily market noise! Single-day swings are almost always completely meaningless in the grand scheme of things anyway.

When you come back tanned, rested, and good to go, patiently wait for high VIX levels. When the VIX hits extremes, go long the QQQs, sell your QQQ puts, and buy QQQ calls. Piece of cake!

Will this strategy continue to work and yield legendary profits for QQQ speculators in 2003? Only time will tell, but after you finish this essay I believe you will have to admit its track record thus far in the NASDAQ bust is incredibly impressive and alluring.

Please consider the following graphs, first the PCR 21dma short signals and then the VIX long signals, both of which are updates from the prerequisite essays mentioned above if you'd like more background information on them.

The 21-day moving average of the Put/Call Ratio has traveled in a well-defined trend channel in the past couple years. Provocatively when it bounces off of its heavy bottom support line, marked by the numbered arrowheads above, it has yielded excellent shorting signals quite close to major NASDAQ interim tops.

Why is the PCR 21dma's trend channel rising? Probably because slowly but surely market players worldwide are wising up to the NASDAQ bust and starting to understand its ominous and awful implications.

Fewer and fewer stock bulls are fooled on each subsequent bear-market rally so relatively more puts, bets the NASDAQ is going to fall farther, are traded compared to calls as each new bear-market rally tops. With relatively more putting activity compared to calls accelerating over time as folks wise up to the Great Bear's dire threat, the PCR trend is up. General fear is growing as The Ultimate Bottom inches relentlessly closer!

The numbers in the graph above are important to help understand why this particular NASDAQ bust speculation strategy may prove valuable. Each numbered arrowhead corresponds to the same number along the blue QQQ line. In addition, each number on this graph is a shorting entry point that is closed for a round-trip trade on the VIX graph following down below.

So for example, point 1 above is the short signal in the PCR 21dma and point 1 below in the VIX graph is the long signal that closes out this exact same particular trade. Trade 1 is opened on the low PCR 21dma short signal above and the same trade 1 is closed below on the high VIX long signal.

To compute the past performance of this NASDAQ bust trading strategy, we need to know the exact NASDAQ levels that occurred on each PCR 21dma short signal. The actual daily NASDAQ and QQQ closes that correspond with each PCR 21dma short signal shown above are recorded in the final table below after the VIX graph.

The latest PCR 21dma short signal, number 6 above, occurred on December 2nd, 2002 at NASDAQ 1485 and QQQ $28. In the days leading up to this event we were eagerly stalking this forming PCR 21dma bottom so we gave the green-light go signal in Zeal Intelligence for our subscribers to deploy their Big Trade QQQ puts speculations. So far this has proved to be the latest interim top and a wonderful shorting point, although only time will tell if the NASDAQ's spectacular late 2002 bear-market rally is indeed dead as the PCR 21dma strongly suggests.

One final note is in order on the PCR 21dma. I thought it was interesting to observe the PCR 21dma behavior immediately after its interim bottoms. Note above after short signals 2 and 3 how the PCR 21dma kind of slowly chewed its way higher roughly parallel with its trend pipe for a couple months.

These episodes corresponded with valiant post bear-rally-top attempts to rally the NASDAQ back higher. Some of the perma-bulls sure don't seem to be learning the hard lesson very well of the immense clear and present danger a Great Bear bust poses to their scarce capital. As each bear-market rally fades, call option buying activity (hence a low PCR) stays relatively high as hopeful optimism springs eternal. It would not surprise me one bit to see the PCR activity after our current short signal 6 exhibit the same sideways upward trend-parallel chopping behavior in the early months of 2003.

Now that you've seen the short entry points, please check out the long entry points (or short exit points) signaled by VIX extremes.

As I have discussed in about a half-dozen essays on volatility and the VIX now, extreme volatility is almost always a telltale sign of extreme general fear. The whole game of speculation is to buy low and sell high, and prices are usually near interim lows and blood flowing in the proverbial streets when the VIX spikes to stellar extremes around 50.

If you are a speculator who only watches the NASDAQ or S&P 500 indices themselves, you can see all kinds of down days but never have any idea when an interim bottom may have been laid in. But if you also watch an exogenous technical indicator like the VIX that happens to be a fantastic proxy for general fear, there is a high probability that you will have an excellent idea of when a short-term bottom has arrived. If the VIX soars into the 40-50 range, odds are a bounce is rapidly approaching and a spectacular bear-market rally is imminent.

The VIX consistently provides outstanding long signals to compliment the PCR 21dma's outstanding short signals. Is it a match made in speculation heaven?

In order to retroactively compute the potential profits from our binary PCR 21dma and VIX NASDAQ bust trading strategy, we need to know the NASDAQ and QQQ levels on the days each VIX peak marked above was reached. Also please recall that the numbers in the VIX graph correspond to the same trade number in the PCR 21dma graph above.

The summary table below records the actual NASDAQ and QQQ daily closes corresponding with these sentiment trading signals. Numbers 1-6 in this table correspond with points 1-6 in the graphs above. The upper left quadrant details the actual market data at PCR 21dma interim lows and the upper right quadrant details the actual market data at the VIX spike interim tops.

The lower two quadrants reveal the actual results of using this PCR 21dma/VIX NASDAQ bust trading strategy. The lower left quadrant shows the short profits in NASDAQ downlegs on shorting at a PCR 21dma low and closing the position on the next extreme VIX spike. The lower right quadrant shows the long profits achievable in NASDAQ bear-market rallies by going long a VIX spike and closing the position on the next PCR 21dma low.

OK, to recap we are shorting the NASDAQ via the QQQs at PCR 21dma bounces and going long at VIX extremes. How would this strategy have worked in the last two years of the horrific NASDAQ bust? In a word, awesome!

The average unleveraged QQQ downleg short gain is 36.9%! The average unleveraged QQQ bear-rally long gain is 28.8%!

These profits are outstanding for a supercycle Great Bear market! In 2001 and 2002 the PCR 21dma/VIX sentiment trading strategy has won on every single trade. While the raw gains are impressive, these can be leveraged tremendously with carefully chosen QQQ options to reap magnificent profits an order of magnitude higher or more!

For example, an actual Zeal Intelligence newsletter QQQ options trade we recommended to our subscribers when the first "Trading the NASDAQ Bust" essay was published last February closely followed short trade 3 shown in the table above. We purchased and recommended QQQ Sep 30 Puts in the February 2002 issue of ZI and closed and recommended selling this trade in the August 2002 issue of ZI.

During the six months between these two newsletters the NASDAQ fell 31% and the QQQs fell 38%. But, through the magnificent leverage of options, our subscribers harvested a large 350% realized profit on their QQQ Sep 30 Puts. This awesome leverage is why we choose to always trade the QQQ options rather than the underlying QQQs themselves.

This actual real-world real-time trade also yields another important lesson for speculators. While it is easy to discern exact PCR 21dma interim bottoms and exact VIX interim tops on a graph with 20/20 hindsight, it is impossible to pick the exact day when these sentiment trading signals flare up in real time. Interestingly however, this is not a problem at all.

To trade very successfully and be blessed with huge profits through the ongoing NASDAQ bust, all a speculator needs to do is catch the middle 80% or so of each major NASDAQ downleg or bear-market rally. The actual QQQ options trade mentioned above didn't hit the exact tops or bottoms, but so what? We were still blessed with fantastic profits even though we only caught about 7/8th of downleg 3.

Exact timing to the day is impossible to consistently achieve and irrelevant. All that matters for profitably trading these major NASDAQ bust moves is to short somewhere near the interim tops and go long somewhere near the interim bottoms. Interestingly, legendary speculator Jesse Livermore said to never fight for the last 1/8th in a trade because it is always the most expensive.

Greedily lusting after each full move is dangerous and will eventually prove disastrous. A prudent speculator merely trades around the time the PCR 21dma looks to be bottoming and around the time the VIX looks to be topping. Even catching the middle 80% of a major NASDAQ bust swing with QQQ options still yields phenomenal rewards!

Of course, not only the NASDAQ downlegs but also the fleeting countertrend NASDAQ bear-market rallies inevitably following these downlegs may also be actively traded by speculators. The same PCR 21dma and VIX signals can be used for these trades also. Simply go long, sell puts, and buy calls on a VIX extreme, then close these positions at the next PCR 21dma bottom.

While it is certainly more dangerous to speculate countertrend, temporarily betting against the primary bearish market downtrend, we enjoy risking our capital at this game too. Our Zeal Intelligence subscribers and we were blessed to ride the last bear-market rally in the NASDAQ which probably ended in late November to 65% realized gains in QQQ calls and 189% realized gains in some calls on our old whipping boy JPM.

With both the benefit of back-checking this strategy as well as harvesting some excellent real-world options trades last year riding the NASDAQ bust both short and long as appropriate, trading this ongoing Great Bear bust using the PCR 21dma and VIX as technical signals looks extremely promising.

Using the two binary exogenous technical sentiment indicators is easy. All you have to remember is long on fear and short on greed. You can find the daily VIX close for yourself at Yahoo Finance under the symbol ^VIX and the raw PCR data direct from the CBOE at this link. (To then find the PCR, scroll halfway down this page to click on the tiny "Final volume … found here" link.)

When the markets are suffocating in fear during a huge VIX spike, throw long. Buy QQQs, sell any outstanding QQQ puts you are carrying for enormous profits, and aggressively buy QQQ call options. Then sit back and relax and wait for the bear-market rally to unfold over a couple months or so.

Then, near the top of the bear-market rally when the PCR 21dma bottoms indicating the majority of investors are complacently convinced that the Great Bear is finally extinct, throw short. Sell QQQs, close any QQQ calls you own to harvest large profits, and buy QQQ put options like there is no tomorrow. Then take a market vacation for at least a few months and patiently wait for the vicious bear to do its gruesome work and once again relentlessly grind the NASDAQ and QQQs lower.

Our Zeal 2003 NASDAQ bust macro-speculation strategy is indeed this simple! Go short on a low PCR 21dma and go long on a high VIX.

If this kind of practical research and real-world real-time QQQ options trading based on it interests you, please consider subscribing to our acclaimed Zeal Intelligence newsletter to support our ongoing research work at Zeal Research.

In these private monthly newsletters is where we publish our most valuable and timely trading information for active speculators as well as analyze real recommended trades before, during, and after their executions. Our newsletter is the practical real-world application of the ideas discussed in these Zeal Web essays.

As a matter of fact, we just recommended a brand new specific QQQ options trade based on this strategy in the new hot-off-the-presses January 2003 issue of Zeal Intelligence. This trade has an excellent probability of achieving profits in the hundreds of percent later this year as the NASDAQ bust rolls on. If you honor us with your subscription today, you now have the opportunity to buy this exciting QQQ options play at a low price far superior to the entry price my partners and I attained earlier this week.

2003's continuing NASDAQ bust is likely to be similar to the 2002 bust I wrote about last year in the first installment of this essay. While it is the same old bust, it is still really exciting to watch it unfold with our own eyes and learn how to successfully trade it. All speculators today are very blessed to have an exceedingly rare opportunity to witness and trade through a real bust themselves rather than merely read about it in dusty old history books!

As this brutal NASDAQ bust grinds on, speculators across the globe are continually refining their strategies and models and growing more sophisticated at trading it. I truly hope our idea of combining the PCR 21dma and VIX to better time the downlegs and bear-market rallies proves valuable for your own personal speculations.

Will our new NASDAQ bust trading strategy prove immensely profitable in 2003? Only time will tell but it will sure be fun trading and watching it all unfold!


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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