Is the Market Due for an Oversold Bounce?

Posted On January 25, 2022 1:19 pm

Monday saw indices staging their largest single-day reversal in 14-plus years as the Powershares Nasdaq 100 (QQQ) erased a 4.3% to finish 1.6% higher.  Similarly, the SPDR S&P 500 Index (SPY) closed 5.1% above the intraday low. 

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This had all the hallmarks of a capitulation day.  Here’s what I wrote to Options360 members as part of my midday Alert to establish a SPY bullish position:

We are now approaching the ‘whoosh’ that often accompanies panic selling and can often signal a short-term low.

We are certainly getting major oversold readings, today is the second 90/90 day (that is breadth is 9-1 negative and down volume  90%) the options put/call ratio has hit 1.30, the highest level since March 2020, and the VIX has popped some 26% to 36 and is clear backwardation. Other sentiment gauges such as the fear/greed index have hit are at extreme bearish. 

This may not be the bottom but I think we get a tradable bounce in the short-term.” 

To be clear, I was and am not calling a market bottom; simply a bounce.  The position the Option360 Concierge Trading Service established will expire on Friday, Jan 28 — meaning it’s a very short-term trade. 

However, in the bigger picture, I’m doubtful as to whether Monday represented a sustainable low.  First, we need to be aware that some of the sharpest rallies occur within downtrends (bear markets). Note: At Monday’s low, the QQQ was 19% off its high; just shy of the 20% used to generically define a bear market. 

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Indeed, this morning the indices are back down over 2% at midday.  This type of back-and-forth volatility is often associated with the formation of markets rolling over.  The saying goes, bottoms are made with a spike or “V” formation when everyone throws in the towel.  Tops are formed by a process of lower, higher and lower, lows which ultimately wears everyone out, leading to the aforementioned “V” bottom.

It might not be this week or even this month. However, I do believe the market will make a new low before a sustainable bottom can be found.  Essentially, it could be a rough ride with whipsaw action for the next couple of months as the market transitions from liquidity-fueled speculation fever to tighter monetary sobriety. 

Keep in mind, the indices typically have at least one 10% correction per year.  We just had our first in over 19 months. Also, note that these corrections usually come in clusters and are associated with bear markets. Again, violent rallies within a downtrending market-creating lower lows.

one year market correction averages

This doesn’t mean there won’t be some good trades from the long in the coming weeks. But, you must pick your spots, keep tight stops, and proper size allocation. 

Likewise, when looking to short a stock, ensure that you have a well-defined entry point against resistance and don’t be stubborn about staying with it — as rallies can carry further and faster than you thought possible.

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.