Three trend lines stand out in this chart.  All are ascending.  The lowest line traces the trend of higher lows that started in November.  The top line tracks the trend of higher highs and the middle line follows the trend of higher lows, but only since late December.  The top two trend lines create the boundaries of the trading channel that the SPX has been trading within for a month and a half.  Each touch of the upper trend line (as seen on Friday) results in a flat to lower market for the following few days until the lower trend line catches up to offer support.  This trading channel will break apart at some point and the cracks tend to come to the downside, especially after such a long run within a narrow path.  That is when the lowest trend line will be tested again.  This line is not much lower, but would give the index a much needed rest period to consolidate its gains.  A fall below this trend line could foreshadow much bigger losses to come before another area of support is identified by traders.

While the trend lines battle out support and resistance, the moving averages have their predictions to make.  The large cap index is trading above all of its moving averages from as short as 5 days to 200 days.  This is a bullish sign in itself, but always comes to an end eventually.  The first key moving average to watch is the 10 day moving average (dma).  The SPX has not had a full day trading below the 10 dma since mid-December, when the last mini-correction bottomed out.  This past week saw multiple intraday crosses of the line which in itself is a red flag for bulls.  Early in the week the S&P closed on the moving average one day and beneath it the next day.  If the following day would’ve been a confirmation day lower, chartists would have expected a much bigger sell-off to ensue.  Instead it recovered and kept the bears off the playing field a little longer.

Traders will quickly shift their attention to the nearest area of potential support once the 10 dma breaks.  This will result in a sudden drop in stock prices until the index reaches its target.  That target could be the 50 dma which just had a bullish crossover above the 200 dma.  Moving average crossovers that see a shorter time frame move above a longer time frame tend to signal better days ahead.  Unlike trading channels marked by trend lines, rallies defined by moving averages do not move in such straight paths.  A retest of the 50 dma would be considered healthy before the next leg of the bull market took place.  If traders see support work at the 50 dma they will pull money off the sidelines and into stocks very quickly and investors will be in store for another long run higher.

As with the trend lines and moving averages, the Williams %R indicator is not giving a sell signal yet, but does show a reason to suspect a period of consolidation is due.  As long as the indicator is in the gray overbought area then the rally still has momentum on its side.   Investors can expect further declines to follow once the indicator moves below -20 for at least two days in both the 14 and 28 day periods.  When the indicator climbs above the -1.0 area as it did on Friday, the next few days tend to be flat to lower.  In other words, Williams %R is in agreement with the trend lines.  While the future has promise, the next few days are not the time to buy into it.  While an active trader might risk shorting the index now, an investor with a longer time horizon would be wise to wait for a clearer bearish signal before taking profits.

I saw the S&P 500 open almost directly in the center of the ascending trading channel I’ve been watching and figured SPY would be a quick and easy way to gain market exposure.  While SPY was trading at $133.96 I sold one SPY March $132 naked put for $2.23 and received $222.42 after commissions.  By no means is this an aggressive play.  The strike is below the intraday lows for the past three days, below the two trend lines of higher lows I’m tracking and below the 10 day moving average.  It only allows for a 1.71% gain (14.4% annualized) in the next six weeks and a day.  SPY can fall 3.09% and still leave me at break even.  The ETF can even drop 1.4% and I’ll still take a full profit.

I chose this specific strike for a couple of reasons.  I wanted the time horizon to be short.  February expiration was too short which made the premiums too small, so March was the next best expiration.  Also, I didn’t see the need to be overly aggressive when I was so excited about the jobs report and the ISM Service Index report.  Sometimes the excitement can push me (or any trader) into taking excessive risks.  Making 14.4% on top of my 6+% gains I’ve already earned this year will make me happy enough.  Also, I’m not done trading.  I’m going to continue adding more exposure as this option and my other stock index ETFs pull farther out of the money.  My February DIA and IWM puts are getting cheap enough that I’ll probably buy them back on Monday or Tuesday and roll them to higher strikes further down the calendar.  Lastly, this trade brings me up to almost fully invested, but with a lot of out of the money puts in place.  I’ll push my account over 100% invested in the coming weeks, but with out of the money puts in most instances.  I’m all about the higher probability trades lately with the theory that I’ll be able to reach my goals with frequent small bites.

I’ll be able to continue buying my puts back for next to nothing prior to expiration if the market continues to charge ahead like it has been.  This shortens the time horizon that I originally used in my calculations and improves my annualized gains each time I successfully roll an option out further in time and to a higher strike.  By staying out of the money when writing my new naked puts I’m setting myself up to move further ahead of the markets’ returns when the inevitable next correction hits equities.

At the beginning of December, I charted the S&P 500 index and pointed out how the 50 and 100 day moving averages (dma) crossover tends to foretell the early days of a longer bull market.  So far that prediction has held true.  These moving averages had their bullish crossover on December 1st on the DJIA chart too.  Since then the Dow has pulled away from its 50 dma by more than 500 points.  During this run higher the index has followed a tight trading channel as shown by the three trend lines in the chart below.  Each touch on the upper end of this trading channel’s trend line of higher highs sends it lower for a few days until one of the lower trend lines of higher lows comes back into play.  On Friday the two lower trend lines converged just below the 10 dma and acted as support.

Now the question is – how much longer can this tight trading channel last?  It’s uncommon for stocks to maintain such a narrow trading range for more than a month, if even that long.  It’s been more than 31 days for the DJIA so far.  In all likelihood this collection of 30 large cap stocks won’t maintain its trajectory for much longer.  Another trip to the top end of the channel could be its last move to these elevated levels for weeks.  We might not even see it get back up there before the Dow finally cracks again.

Investors should watch the trend lines of higher lows and the 10 dma to see if any of these technical indicators break support.  The 10 dma has broken support intraday only a few times since mid-December, but always closes above it by the market’s close.  The same thing happened on Friday again.  Closing below it will be the first major red flag for bulls.  The warning goes for the shortest trend line also.  Now that this chart’s longest trend line is moving above the shortest trend line, the space the Dow will be “allowed” to trade within will be increasingly narrower as it chases the upper trend line.  One line will have to give and it tends to be the lower ascending line more often than the upper ascending line.

Once support breaks the next question will be - how far will the DJIA fall?  As I mentioned at the beginning of this analysis, the 50 and 100 dma crossover tends to spell out longer bull market rallies.    That doesn’t mean we won’t witness a few minor corrections along the way.  Investors should expect the DJIA to test its 50 dma multiple times during this extended rally.  A move back down to its 50 dma from Thursday’s intraday high would mark a 5% correction and could be all the market needs as a catalyst to reduce allocations from bonds and into equities.  The first half of 2011 was filled with 4-5% mini-corrections.  2012 is ripe for one.

The first small hint that the move lower is upon us can be seen in the Williams %R indicator.  It fell below the overbought level on the 14 day indicator by the end of the week.  It needs a couple of confirmation days lower along with the 28 day period cracking too for it to show a true sell signal.  At this point, even a single confirmation day could also bring about a close below the three demarcation lines I mentioned above.  It’s time for active traders to be ready to take some profits or add some hedges.  Investors focused on the longer term might not need to panic yet.  The chance of a sell off beyond 5% is low, but could quickly change if the 50 dma doesn’t hold support.  Stay nimble and watch the charts.

I kept the expiration to the closest month to target a quicker profit and keep the contract easier to exit if we see a bigger momentum shift.  More than likely I won’t buy it back, but will be able to work a covered call with it quicker this way.  By selling in the money with such a short time horizon I didn’t gain a big advantage.  I only have a 0.92% cushion.  The profit potential is 2.15% or 32.9% annualized.  I thought about just buying the shares, but I’d rather have 0.92% cushion than none.  More than likely this trade will lead me into owning 100 shares of SPY.  Adding another 2.15% in the next three weeks might be all we could ask out of this market anyway.  Any more than that so soon and it really might be a better time to stay in cash or start shorting the market. Either way, I get to re-evaluate in the near term.

Hours later and another few points lower for the indexes I made another trade.  My SPY trade took the haste out of my trading since I had more exposure again and let me be more patient with this trade.  While IWM was trading at $79.15 I sold one IWM March $77 naked put for $2.02 and received $200.97 after commissions.  Since I’m not convinced how long this rally has legs, I sold this put out of the money and gave myself a longer time horizon.  With that I gained a 5.26% buffer before I take a loss.  I still stand to make 2.68%, 19.1% annualized, if it works out.  If I’m assigned the small cap ETF shares, then I’ll be set-up to start the first quarter off with a good lead over the indexes.  If I’m forced to buy, my cost per share will be $74.99.  That’s just below the 50% retracement level using Fibonacci lines from the December intraday low through today’s intraday high.  That’s also the point of resistance during November and December and then was support (at $75.61) in January.  This is going to be a key level to watch if/when IWM gets back down there.

My plan on this option is to make a small gain while the ETF losses value.  If I was more patient I would’ve waited for small caps to sell off more first, but I’m not confident enough in how low it’ll go before turning higher again.  I needed room to profit on a continued rally.  I’d be a straight out bear if the trend line of higher lows had broken, but the indicators are still pointing higher.  This leg of the rally is just lasting longer than most of the recent ones.  That simple fact doesn’t mean it’s over, it just means I’m being more cautious since the easy money is done.

I’m 81% invested now and still want to add more, but don’t have to chase as hard after these trades.  I plan for my next trades to be out of the money puts again.  Ideally I’ll be able to make trades with a minimum of 15% annualized gains and lower risk.  I need the VIX to pick up a little more to help me with that.

I didn’t wait for this expected dip because I don’t think any move lower is going to last too long and I’m not always perfect on exact date picking.  Having out of the money option exposure gives me the best of both sides.  I make money if IWM stays flat or moves higher and don’t lose as much on the next step backward, whenever it gets here.  As it stands, I could make 2.22% or 32.0% annualized if it works out.  I only have 2.48% downside to cushion any the trade before I take a loss, but with only three and a half weeks to go on the contract that’s not too bad.

I thought about selling a naked put on MDY next, but since I was already long 100 shares I thought I should sell covered calls on it first.  I might circle back as early as tomorrow to sell naked puts on MDY too.  While MDY was trading at $169.77 I sold one MDY March $175 covered call for $2.50 and received $249.37 after commissions.  If MDY stays within the trading channel it’s in now I will have left money on the table.  I gave the position another 4.55% of upside potential from here.  I’ll be happy to walk away with that in my pocket if the covered call is assigned.  I’m already up more than 5.5% for the year, so another 4.55% would be a great place for me to reassess what I’m targeting.  Then again, the 4.55% doesn’t cover my entire account, just this $17,000.

In hindsight I don’t know if I should’ve sold these covered calls yet since I don’t have much other upside potential in place.  It’s easy to second guess myself since the indexes shot up after I made my trade.  The SPX bounced from its trend line of higher lows all of the way up to its trend line of higher highs and used its 10 day moving average as support again.  In the past when the SPX has hit its upper trend line it moves sideways to lower for the next few days.  That’s not to say it’s going to fall below the 10 day moving average yet.  Until it does, the upward bias remains in place and I know I should’ve stayed invested deeper.

While UCO was trading at $40.71 I sold three UCO March $37 naked puts for $2.00 each and received $599.01 after commissions.  If assigned, which I’m half expecting to be, my cost per share will be $35.00.  That’s 14.01% below the price when I made the trade.  More importantly, it’s almost dead on the midpoint for the ETF over the past six months and $1.00 below the intraday low from the past two and a half months.  I expect support to surface before I take a loss.

This is a half position for me on UCO at a total cost if assigned of $10,500.  I’m willing to go up to 20% of my account in UCO and maybe more if the price goes low enough.  I didn’t need to go for a full position yet.  As I mentioned, UCO has looked weak lately – not enough to keep me out of it, but skittish enough to make me somewhat careful.  If the trade works out for me I’ll make 5.69% or 38.47% annualized. With potential gains like that I have no need to overextend myself.  I almost went with a lower strike to make it a safer trade, but with only 300 shares at risk I think my downside risk is limited.  If assigned, I’ll run the same pattern I’ve done for a while – accept the assignment, sell new covered calls out of the money with new naked puts out of the money.  If possible I’ll try to make money on the shares themselves, but with such great premiums I’ll be happy to break even on the shares cost while I continue to rake in the premiums at a lower price.

The biggest risk to this trade is that the dollar strengthens faster than demand can keep the price of oil afloat.  That happened briefly last year as the fears of what would happen in Iraq diminished.  Oil nose dived, but then it came back and all was fine in UCO-land.  Iraq is back in the picture again recently and its impact will come and go for years to come in my view.  I’m discounting that and still believe this trade’s risks are worth its potential return.

I’m still very under-invested elsewhere.  As I mentioned in my S&P 500 chart this past weekend, the upside looked limited.  SPX is nearing potential support now that it has stepped lower.  If support surfaces I’m going to have to hustle to get some exposure back in place.  I’ll probably start adding more index ETF puts tomorrow, just to make sure I have more skin in the game albeit with out-of-the-money puts maybe.  Small caps found support on IWM’s 10 day moving average and a trend line of higher lows.  I want to see how that opens tomorrow before I really go after it.

As I mentioned last week in my Dow Jones chart, technical analysis can be an art as much as a science when using certain technical indicators.  Three of my go-to indicators are trend lines, moving averages and Willliams %R.  None is telling the story of a major sell off coming yet on a scientific view, but the art behind them might be whispering something different.

The S&P 500 moved to the top of its trading channel again on Thursday and hit resistance at the trend line of higher highs.  Each time it has done this over the past month it was foreshadowing of a few points lower in the coming days for the index.  Lately it’s only been a few points, some sideways days and then another run higher.  As with each pattern, this only works for so long.  So after the third touch to the upper trend line I started to wonder if this is the last time the large cap index will use this same trend line without having a bigger dip.  The science says don’t ditch the rally until the lower trend line has broken.  The art says to be wary after such a long run.

The lower side of the trading channel is approaching 1,300 quickly and would allow for a 15 point drop, barely more than 1%.  1% is hardly worth noting, except that this has been the pattern since mid-December and is due for more of a shake-up.  The lower trend line of higher lows that started in November could easily be a good area of support 40 points lower.  This would allow a 3% step down and allow in more buyers who missed the beginning of the rally, but are scared to get in at the current level.  If it happened quickly enough it would move the S&P close to its horizontal line of support around 1,267.

The science behind the moving averages says ride the rally.  We haven’t seen any bearish crossovers and the SPX is above each time frame I watch.  The art says the SPX has moved so far above its moving averages that if we wait until they have a bearish crossover we will have missed the first 3-4% of the sell off.  Since I’m bullish for the year, I’m not sure how big of a sell off we’re going to get and missing 3-4% could be half, if not most of a sell-off in 2012.  The moving averages certainly don’t call for shorting quite yet, but they do indicate it might be time to take more off the table to see how the next week or so plays out.

Williams %R hit the ceiling of its indicator for overbought on its 14, 28 and 56 day periods.  I always preach the science says don’t sell until the indicator has fallen below the overbought range for more than two days.  The art says going neutral at these extreme levels can be a safer way to work the indicator.  Williams %R can stay in the overbought range of long periods of time, but rarely stays this close to the “-0″ area for long.  Williams %R isn’t showing a sell signal, but it is saying the gains from here should be limited.

Volume is still stuck in the lower side of its average.  Friday’s pop was probably only due to January options expiring.  I’m taking it with a grain of salt, especially with the flat day we ended up with.  Indicators aren’t saying its time to run for the hills yet, but with so little upside available with all of the indicators, there’s not a lot of reason to be heavily invested right now.  The downside appears to be the path of least resistance over the next couple of weeks.  That doesn’t mean it can’t melt up, but any spike seems like it should be sold as a last ditch effort by the bulls.

• CSX – 1 January 20.83 COVERED CALL - Expired in the money which means my shares will be called away.  I finished the series of trades with a loss of $123.04.  I don’t think I’ll be back in on CSX for a while.  I’m not saying it’s a bad stock; I’m just eyeing other trades.
• DDM – 1 January 51 PUT - Expired worthless.  I’ll probably just work with DIA in the future, but might drop this one in sometimes when I want a lower priced tool to work with.
• JPM – 2 January 33 COVERED CALLS - Expired in the money which means my shares will be called away.  I finished the series of trades with a loss of $691.79.  I could’ve kept working the position longer and continued to be patient with it to make more money, but I think there are better opportunities to work my money elsewhere that have less volatility.  It was time to take the loss and move on.
• MDY – 1 January 160 PUT – Expired worthless.  See next bullet.
• MDY – 1 January 175 PUT – Assigned 100 shares at $175 as of this morning.  I could’ve bought my option back yesterday for around $6.00 and made $1600+- (~10%), but wanted to ride it to through expiration with the intention of selling a covered call after the shares were assigned after Friday’s close.  Once I had a chance to step back and see how empty my account is after today’s expiration I thought I should delay selling covered calls.  I need some upside potential in place without an option putting a ceiling on it.  The markets could fall and I might have been wise to cover this position, but I’m far less than 50% invested right now and one ETF falling wouldn’t be such a bad thing with so much cash available on the sidelines.
• QCOM – 1 January 52.5 PUT - Expired worthless.  There’s no way I can stay away from QCOM for long.  It’s become one of my constant positions through options.  However, I’d like to see it below $57 again before I sell my next put.  Seeing the March contracts would be good too.  Right now the February contracts aren’t worth enough and the April contracts are too far out.
• RSP – 2 January 48 PUTS - Expired worthless.  I’ll be back to trade RSP again.  I’d like to see it come down a few more cents first.  I think it’ll poke below $48.50 fairly soon and then I’ll sell another naked put when I see it hit support.
• TBT – 5 January 18 PUTS - Expired worthless.  A couple of days ago TBT looked like it was going to be down to the wire as it dipped below $18 for three days ending on Wednesday.  Now that it’s at $19.28 late in the day I’ll have to wait for the next drop before reopening this trade.  I might even go with a $17 strike next time, but probably not since support seems to still be close by the $18 strike.  The risk still seems small when premiums are added in.
• UCO – 3 January 35 PUTS - Expired worthless. More below.
• UCO – 3 January 40 COVERED CALLS – I thought these calls had a chance of finishing out of the money when UCO fell down below $40 earlier in the day, but then it recovered.  I decided to let my 300 shares get called away after coming very close to rolling my covered calls to a February $38 strike.  When I checked the put premiums I saw that I could do better with puts than covered calls.  So I deleted the order I was setting up.  UCO has been faltering some lately so I decided to give it another day before selling new puts.  This will close out my UCO position that started early last year in April.  UCO is much lower now than it was when I sold that first naked put of this series of trades.  UCO was trading at $61.27 then and is at $40.67 mid-afternoon today.  Even with this huge decline, thanks to the power of options I ended with a profit of $1,923.65.  It never gets old making a profit while the underlying stock or ETF declines.
• UWM – 2 January 30 PUTS - Expired worthless. More below.
• UWM – 1 January 35 PUT - Expired worthless. More below.
• UWM – 3 January 40 PUTS - I decided to close out all of my leveraged ETF exposure while I had a profit in hand.  While UWM was trading at $38.95 I bought to close three UWM January $40 naked puts for $1.10 and paid $330.97 with commissions.  My net premium total received on these two trades was $1,646.63.  Buying them back today gave me a realized profit of $1,315.66.  In January, UWM was trading at $43.66 when I sold the first LEAPS.  In May, UWM was at $48.65 when I sold two of these puts.
• UWM – 1 January 45 PUT – Same idea on this higher strike on the same ETF, pocket profits and move away from leveraged ETF exposure (I’ll be back with UCO soon).  While UWM was trading at $38.97 I bought to close one UWM January $45 naked put for $6.10 and paid $610.62 after commissions.  This gave me a realized profit of $458.37 while UWM lost value from when I sold the put in December 2010.

I had a few other options expire in my TD Ameritrade account too that are also worth mentioning.  Since I sold these while I was blogging about that account I thought I should include how they finished at expiration.

• SSO – 2 January 40 Puts – Expired worthless, took a full profit.
• UWM – 4 January 30 Puts - Expired worthless, took a full profit.
• UCO – 1 January 35 put - Expired worthless, took a full profit.

The chart below shows multiple horizontal lines that have worked as support or resistance over the past few months.  It illustrates the reason I expected support to show up yesterday or today and where I could see TLT rallying towards.  TLT had held at the same (or very close to the same) intraday low for weeks.  I thought we might see a dip closer to $115 before it came back to life (which is why my March limit order didn’t hit today), but today showed the turn sooner than expected.  I’d like to see the ETF move back towards the $122 area before it takes another dip.  Otherwise today could just be a blip higher on a longer trend lower.  If TLT gets back up to the next horizontal line before my TBT (ultra short 20+ year treasury ETF) options expire I’ll keep both sides open to see which one works out.  I’m planning on both sides going my way.  If I can make it through next week with my TBT January $18 puts still being out of the money I’ll re-write new contracts to go along with this TLT expiration in February.  I plan to work this trading range until it no longer works.  The only change I might make is lowering my TBT strike to $17 since $18 didn’t offer support as I thought it was going to last time.  Then again, the sub-$18 move was short lived.

The upside is limited at some point due to the extremely low yield 20 year treasuries are already offering.  The yield isn’t worth the downside risk when TLT is above $125.  This is why I like selling TBT naked puts when TLT spikes.  There’s enough fear in the markets to offer support when TLT falls closer to $115 and the yield improves.  My cost per share will be $115.80 if I’m assigned today’s option contract.  I have a hard time seeing TLT drop more than another $5 from there (the bottom horizontal line).  I’ll be able to stay long, receive a good dividend and write out of the money covered calls every month or two and maintain a profitable position fairly easily.  And that’s if the position goes wrong for me.  If TLT does tank, that will mean my equity positions are doing well in most scenarios.  That day will come, but I don’t think it’ll be in 2012.