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About That Crash...

Written by Briton Ryle
Posted February 6, 2018 at 7:00PM

Last Wednesday, January 31, I sent a trade to my Real Income Trader/Options Trading Pit subscribers to get in some CBOE Volatility Index (VIX) call options (volatility rises when stocks sell off, and call options are an upside trading vehicle).

The VIX was about $14 when I sent that trade. It's gotten as high as $50 since. We didn't catch that whole move, but still, we did pretty well...

Now, I'll tell you right out: I was not expecting to see the Dow drop 600+ points on Friday and another 1,200 on Monday. And while my analysis showed that more selling was imminent, I'm not sure there's any analytical method that can nail a 10% drop for the Dow. 

Still, I want to take a minute and sort out what happens when the market plunges like that. We've talked about this before, but the market is 70% driven by computer algorithms. That means, when in "buy mode," the computers seek out sell orders and take them out. If a stock is $50, the algorithm will see sell orders at $50.05 and take them out. Then it will probe up to $50.10...

The process repeats and stocks just march higher like they've done over the last few years. It hasn't been uncommon to see the S&P 500 put in 0.3% advances for like eight days in a row. We like that just fine when the algorithms are on "buy." 

But when they get switched to "sell," the opposite starts happening. The algorithms want to sell, so they start looking lower for "buy" orders. So they'll start at $50 on that hypothetical stock, and they'll head to $49.90 and see if there are buy orders. Then they'll drop to $49.80, and then $49.70...

The problem is that when things go south, there are no buy orders. They get pulled until the dust settles. Meanwhile, the algorithms continue to probe lower, seeking out buy orders that aren't there.

The Flash Crash

Back on May 6, 2010, some stocks fell below $1 because there simply weren't any buy orders and there was nothing to stop the algorithms from probing all the way to zero. This was the now-infamous Flash Crash. 

Regulators put in circuit breakers to try and prevent declines like the Flash Crash. Of course, this type of event can't be stopped. Look at the way Bank of America (NYSE: BAC) traded on Monday...

bac 2 5 18

The stock was pretty strong early, very nearly turning green. The S&P 500 reversed lower, but BofA still hung around $31.80 until about 1 p.m. It fell to its opening price at about 2:15 p.m.

But look at that plunge that started around 3 p.m. Each of those glyphs on the chart represents five minutes. Bank of America plunged from $31.10 to $29 in about 40 minutes, with most of the damage done in about 15, between 3:15 and 3:30 p.m.  

nyse tradersNYSE traders panic as stocks collapse

It's because the algorithms couldn't find any buy orders. So they went lower. And the algorithms clearly switched back to "buy" at some point, because the Dow jumped 700 points in about 10 minutes. You can see that big white glyph that started at 3:30 p.m.

What Happens Now? 

So why did the algorithms switch to "sell" in the first place? It has to do with interest rates and bond yields. People think we may get more than four rate hikes this year, which will push 10-year yields over 3%, and that's significant. Borrowing costs will rise and share buybacks could slow down.

Plus, at 3%, bonds become competition for stocks. Suddenly you don't have to take on the risk of a stock like Procter & Gamble to get a 3% yield — you can just buy a bond

Then there's the fact that stocks have been rallying like crazy for two solid months. Valuations have gotten a bit stretched. Heck, maybe the machines switched gears because the new Fed Chief Jerome Powell just took over. I suppose that could add enough policy uncertainty to change an algorithm's bias. 

But ultimately, the money is always made on the upside. So let's have a quick look at what we might expect in this new age of machines.

We're going back to early 2010 to have a look at the Flash Crash...

flash crash 5 6

Stocks went on a relentless, grinding run higher at the beginning of 2010. For nearly three months, stocks rode that trend channel, taking the S&P 500 17% with barely any pullback. You can see what happened once that trend channel was violated. There were a couple down days... and BOOM! The bottom fell out. The S&P 500 was down as much as 10% on May 6. 

Both that run higher and the Flash Crash itself are textbook examples of how algorithms affect the market

Now, let's look at a current chart...

spx 2 6 18

I am a firm believer that history doesn't repeat, but it does rhyme. And these charts look pretty similar. There's that relentless grind higher, a breakdown out of the trend channel, and then WHOOSH! The market gets crushed for +10% in a couple days. 

If history really does rhyme, expect to see a bounce-back rally for the S&P 500 to around 2,800. If the machines stick to their playbook, this rally will reverse quickly, and we will see a retest of the recent lows of the S&P 500 around 2,600. The index will then waffle around that level for a month as prices consolidate and we get more clarity on Fed policy. 

The bottom line is that the environment has indeed changed. I doubt we see any of those relentless grinds higher for at least a few months. Now is the time to get your trading hats on, because we are likely in for some sideways trading with a downward bias over the next few months.

So far this year at Real Income Trader/Options Trading Pit, we've completed six trades, five of which were winners, and we are averaging 72% gains per trade (winners and losers). Based on the analysis I shared with you today, we bought Micron calls (NASDAQ: MU) yesterday, and it looks like we have yet another winner on our hands.

If you'd like to start making nice, quick profits, you can learn more about Real Income Trader here.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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