Join the Dow Jones Dive Via the Diamonds

by Tyler Craig | August 15, 2013 12:52 pm

Join the Dow Jones Dive Via the Diamonds

A sea of red is greeting investors as they turn on their terminals today. While optimists hope it’s merely a flesh wound, the paranoid are wondering whether the bulls’ comeuppance has finally arrived.

With the 10-year yield (TNX[1]) surging to a new two-year high at 2.82%, perhaps the broader market is finally taking note of the new regime of rising rates. The impact of the rapid rally in rates that has long afflicted utilities, REITs[2], homebuilders[3], and other interest-rate-sensitive securities is now weighing on the entire stock market.

Interest rates aside, the fact is we’re due for some type of correction anyway. History suggests that, on average, the market experiences three 5% corrections and one 10% correction per year. How many of either type have we seen this year?

One.

The May-June taper tantrum led to an 8% downturn, thereby qualifying as one of the 5% corrections. If this year ends up toeing the “average yearly correction line,” then a couple corrections before year end are likely. In case you were wondering, the previous 10% correction ended in May 2012 — 15 months ago. So we’re overdue, but not terribly so.

While all indices are taking it on the chin today, the Dow Jones Industrial Average appears the most vulnerable. It’s actually surprising how relatively weak the Dow has been of late. Take a look at the accompanying chart of the SPDR Dow Jones Industrial Average ETF (DIA[4]), which includes a DIA:SPY ratio (green area). The ratio has fallen off a cliff during the past three months, showing drastic underperformance the by Dow.

DIASPY Join the Dow Jones Dive Via the Diamonds
Click to Enlarge

A closer look at the candlestick chart reveals a double dose of bearishness. First, the price of DIA broke below its 50-day moving average. (Remember, both the S&P 500 and Russell 2000 indices are still above their respective 50- day moving averages.) Second, the RSI has plunged to its lowest levels of the year — well below the 50 zone, which is supposed to provide support during bull markets.

DIA Join the Dow Jones Dive Via the Diamonds
Click to Enlarge

If you think a revisitation of the June lows at $145 is in order, buy the October 150-145 bear put spread on DIA by purchasing the Oct 150 put and selling the Oct 145 put for a net debit of $1.40. The max risk is limited to the initial debit paid, and the max reward is limited to the distance between strikes minus the net debit, or $3.60.

To reduce the risk, consider closing the position if DIA is able to climb back above resistance at $155

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

Endnotes:
  1. TNX: http://markets.financialcontent.com/investplace/quote?Symbol=%24TNX
  2. REITs: http://investorplace.com/2013/08/the-taper-talk-toppled-reits/
  3. homebuilders: http://investorplace.com/2013/08/housing-stocks-stumbling/
  4. DIA: http://markets.financialcontent.com/investplace/quote?Symbol=DIa

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