Banks Are Extended: Rally to Provide Selling Opportunity

When looking around the market, the major Financials look quite extended and could provide a relief bounce. To be clear however, this is a bounce in a downtrend and this rally (should it materialize) will be a selling opportunity.

This week I want to run through the $XLF Top 10 Sector Holdings and show you what I see. During the recent leg lower Financials have been the hardest hit sector. Names like $BAC, $C, and $AXP have been annihilated. Others like $GS, $AIG, and $JPM have come under duress as well.

Financials (XLF)

First lets look at the XLF. This chart shows the weekly prices of the Financial ETF since the 2007 market top. XLF is the only major S&P sector that did not recover to new highs in the recent bull market. This makes it the weakest of the major sectors and those are the places we like to target for potential short opportunities.

The XLF recovered to its 61.8 Fibonacci retracement and has since rolled to the downside. There is the chance we see a relief bounce soon, but ultimately there is very little support for the group until the $17 level. A rally from here will encounter stiff resistance near the $22-22.30 area. I will look to be a seller there. 

The sharpest rallies occur in bear market trends. The Banks are in this category now. These rallies are to be used to position short against. "Shorting into the hole" is what's referred to as taking a short position after a very sharp decline has occurred. Due to the tendency of fierce bear market rallies, shorting into the hole exposes you to the increased likelihood of being squeezed by a sharp rip. Its best to wait for the rally and position your short into a prior support, turned resistance. That way if the rally continues we can easily step aside, or if it ends at the resistance we stand to profit handsomely from the downtrend resuming in our desired direction. Risk/Reward is in our favor by waiting patiently for the setup to form.   

BAC

Bank of America is currently my favorite prospect in the market for a short position. For more than two years the stock has churned in a range between $18 and $15. Since the November high, BAC crashed $8/share down to $10 this past week, that's a 45% drop in two months. 

Seeing the volume that came in on this week's move I'm of the belief that a reversion trade is likely. The stock is trading 30% below its declining 20 WMA and is generally in a position to come back to that long-term average. 

The setup for this potential short entry will be on a sharp rally back into the prior support level at $15. This will require a 25% upward move and I expect that to take several weeks to complete. The time required will allow the declining 20 WMA to meet price near that area as well. We want to sell a rally into this confluence of resistance. 

C

Citi is very much in a similar position as BAC. The stock declined 45% from its recent high and is 30% below its declining 20 WMA. Like BAC, a substantial inflection level exists at the range lows near $46. This can be a great anchor point for new short positions. 

AXP

As you recall we held a short position in AXP from September through early January. The stock is in complete free-fall, recovering to $78 seems almost unfathomable. This will be a name to watch on a bounce, but the levels aren't quite as favorable as BAC and C above. 

GS

Goldman offers a nice clean level to short against as well. During 2015 GS built a textbook Head/Shoulder Top formation and confirmed the pattern on the January 8th breakdown. Since that break the stock has accelerated to the downside. Typically with these patterns we will see a throwback rally to the neckline support level, in this case $170-172. That will be a rally to fade should it materialize. 

AIG

JPM

WFC

USB

AIG, JPM, WFC, and USB all remain right near major support lows. Give or take a few percent these are still likely range bound. Range bound stocks don't make the best trend trades so I would avoid them for the purposes of our potential short positions. 

BRKB

SPG

BRKB and SPG remain the two strongest stocks in the XLF. Due to that fact we will avoid them for our short focus as well. 

We want to be short the weakest stocks in the weakest sectors. For our purposes the stocks to focus on out of this group are BAC, C, GS, and AXP. We have our defined levels to watch for and want to take action when the setup forms a strong risk/reward opportunity. 

It's also possible none of these setups form and we miss out on a trade. If that's the case, so be it. We wait for our pitch. There will always be another trade around the corner that fits our parameters. 

To show exactly what I look for in a short setup I want to review the Emerging Markets ETF EEM. 

EEM

Here is the Emerging Markets EFT EEM. The group traded mostly sideways for a few years, moving between $46 and $36. During the August decline EEM looked a lot like how BAC and C look currently. It declined from $44 down to $30 in a little over 3 months time, or -32%. 

At the low of its decline EEM was trading right around 30% below its declining 20 WMA. With the Fall recovery in the market, EEM was able to bounce back to the prior support level at $36 where it met its rapidly declining 20 WMA. This was the signal to take a short position with a stop loss placed anywhere near the $37-$39 area depending on your timeframe and risk tolerance. Once EEM rolled back over, confirming the resistance, stops could be quickly trailed to the entry point at $36. 

Depending on your strategy you could outright borrow shares to short or make the play via Put options. Personally I prefer using options to trade short positions for a few reasons. First I like defined risk. Part of the risk of shorting is the potential for unlimited risk should the trade move substantially against you. Since you borrow the shares, you owe your broker should anything adverse happen to your trade. This is not something I'm comfortable with. When using Put options you are only ever responsible for the premium you paid for the options. 

Secondly options trade with leverage. Once you define your total risk, the worst you can lose is 100% of your investment (although you should not let your Puts expire worthless, that's just poor management). But the potential gain due to the leveraged nature of options you can easily make 300, 500, or even exponentially more depending on how everything unfolds. Generally I shoot for a max loss of 50% of my premium and a typical gain of 200-300%. That amounts to a nearly 6-1 reward to risk. And occasionally gains can become much larger than that.

Lastly, options obtain their value from price of the stock, time until expiration, and volatility. When trading Put options, volatility tends to increase more rapidly on downside moves. Therefore your trade gains extra steam quickly should price begin to move strongly in your direction.

There are drawbacks to being Long options however as well. Often the stock can move in your desired direction, but due to the decay of the time factor, your trade will actually lose money even though you have been right in the general direction. This is also why I like to be more in and out with option trades. You want to jump in when prices are likely to accelerate quickly, but this is easier said than done. 

Whatever your preferred strategy just be sure you are taking on a risk you are able to withstand and stick to your discipline. Shorting stock is generally more difficult that being Long. The market tends to be in an upward trajectory roughly 75% of the time, so the odds are mostly against being short for a long period of time. When the market turns downward however there will often be opportunities to those who are watching closely and have a defined plan to execute from.

Thanks for reading
-ZT