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This is the point in a rally when some prices can give false clues
09/23/2009 6:01 pm EST
On Tuesday stocks rallied and the price of barrel of oil climbed back above $71.
Upward momentum had been restored, right?
Well, I wouldn't bet on it. At least not with real money. And certainly not on the basis of the kind of prices that are most commonly cited in the press and on Wall Street ,and that most investors follow.
At this stage in a rally I'd call those gross prices. And what you really need to be following right now is what I'd call net prices.
Gross prices are almost certainly misrepresenting the momentum in the market.
Let me use oil prices as an example.
As oil prices have climbed recently so too have the volume and prices of puts in the options market. A put option gives the buyer the right to sell at a specified price in the future. Traders buy them as insurance against--or as way to make money on--a fall in price in the future.
In the week that ended on September 18 the gap between prices for put options and for call options (which give the owner the right to buy at a specified price in the future and are therefore a bet on rising prices) widened to a record, according to data from Bank of America-Merrill Lynch.
In other words as oil prices have been climbing, demand for insurance (put options) against a fall in price has been climbing too. That means the net momentum behind oil prices--once you've subtracted insurance put buying from the rise in the gross price of oil per barrel--isn't nearly as strong as the gross price of oil alone indicates.
Think of it this way. Traders are more likely to keep bidding up the price of oil if they know they have insurance against a fall in price in their pockets. Of course, the cost of the insurance is subtracted from any gain on the price of oil itself. But if you're really worried about a fall in oil prices, it's a cost you're willing to pay.
You're especially likely to pay it if you've made a good amount of money on the long side in this rally. In the process you've developed a commitment to the rally. You don't want to think it can end and you want to stay on board.
Traders are buying puts for all kinds of reasons. Some as insurance. Some are buying puts not as insurance but as a naked bet that the price of oil will fall. And traders at oil companies might be buying puts to hedge against a decline in the price of the oil they produce.
But all these bets are really votes of less confidence in the continued upward momentum of oil prices.
Stocks, like oil and other commodities, come with put and call options. And they too, therefore, may have bets either for or against the momentum of the gross market price.
Keeping an eye on all the markets that influence the net price of a stock is terribly time consuming and I'm not advocating it. What I would advise though is that at this stage in the rally you cast a skeptical eye on price momentum indicators since most of them are only capturing part of the picture.
Add a strong dose of fundamental analysis to any decision to buy, sell or hold right now. If your calculations of the value of a stock show that it's overpriced, don't let an overly simple faith in price momentum convince you that the stock is still a buy or hold.
It's certainly okay to hold a stock that's trading above your calculations of fundamental value since all trends up or down go to excess. But don't let what looks like upward momentum lull you into complacency. Not after a 50% move to the upside.
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