Waiting for a Breakout

12/21/2009 9:31 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, says the market is in a tight range, and traders are looking for it to break out or break down before committing themselves.

Despite some [recent] selling, support [for the Standard & Poor’s 500 has once again held [at 1080-1085], and therefore the overall bullish trend of the market persists. Some of the technical indicators have weakened, but as long as that support holds, they are not important.

On the up side, the resistance at 1110 remains in place as well, resulting in a tight trading range. For four straight days [recently], the S&P 500 ($SPX) opened above 1110 and traded higher, but each day selling pushed the closing back below 1110.

This phenomenon of buying any declines near 1080-1085 has a name that I think is rather apropos: the "Bonus Put." In other words, traders who are due for big bonuses at the end of the year are not going to let the market go down and destroy those bonuses.

The fact that they are protecting their bonuses is akin to the stock market having a long put protecting it. They may be the same traders who are selling at 1110 and higher, but they are buying any serious dip. The worry, of course, is that they will eventually become sellers in the new year, but that's not something investors are worrying about (yet).

Market tops are usually marked by weakening breadth. Our breadth oscillators have given six separate Sell signals over the last month, as $SPX has been unable to break out on the up side. That is certainly a negative sign, and those Sell signals remain in place.

Equity-only put-call ratios have been unreliable ever since heavy hedging activity began last summer. That activity seems to be abating now, so we are tentatively looking to use the equity-only ratios as trustworthy market indicators again. They, too (like breadth), have generated Sell signals [recently].

Volatility indices ($VIX and $VXO) continue to decline, and that is generally bullish for stocks. $VIX would have to close above 25 to potentially change its chart to bearish.

Meanwhile, the $VIX futures continue to trade with large premiums. [The] January premium is 3.70 and February is a whopping 5.50.

The large premiums indicate an overbought market, but Sell signals wouldn’t be generated until the premium peaks and falls below 1.00 or so.

The term structure of the $VIX futures continues to slope steeply upwards, which is another indication of a bullish but overbought condition. This has persisted to some extent since March. A term structure intermediate-term Sell signal would occur only if the structure began to slope downwards.

In summary, both bulls and bears are frustrated—and will likely remain so until a breakout occurs. But once it does, it should be played: A close above 1116 should be bought (or buy calls) and a close below 1080 should be sold (or buy puts).

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