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Don't "Buy the Dip" Just Yet

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Stocks fell this morning after enjoying a massive afternoon surge in the trading session prior. Yesterday, the major indexes initially plunged before reversing, closing slightly higher following an afternoon rally.

And while rampant dip-buying certainly contributed to the bullish reversal, it was a single put seller that sparked the historic momentum shift. At around noon EST, the mysterious put seller appeared, flooding the market with puts. This caused dealers to suddenly pivot from selling S&P futures to buying them via a negative gamma feedback loop that forced an intraday short squeeze as shorts rushed to cover their positions.

Nobody knows who the put seller was. It may have been a hedge fund trying to make some money back before bailing on some losing S&P long positions. Or, it could have been an institutional dip buyer looking to catch the selloff low.

Regardless, stocks reversed again this morning and headed lower once more. The put seller did not return. And, if the S&P doesn’t descend below yesterday’s low, the put seller will have effectively tagged the selloff low to perfection (thanks mostly to the fact that they were responsible for jolting stocks higher).

However, if the S&P does fall below yesterday’s low, the put seller could be in big trouble. Selling puts is a bullish strategy. The put seller would be sitting on a huge loss if the S&P retraces significantly. And, if he/she tries to buy to close those puts to avoid further losses, we could see the market whipsaw lower in epic fashion as puts crowd out calls.

So, even though yesterday’s afternoon rally was a good sign, it’s not necessarily confirmation that bulls are out of the woods just yet.

“I don’t think it’s done,” remarked SoFi’s head of investments strategy, Liz Young.

“This [...] is a digestion process of a new environment that we’re not conditioned for.”

The “new environment” being a rate hike-hungry Fed, which will provide guidance to investors tomorrow afternoon following the January Federal Open Market Committee (FOMC) meeting.

“If you are trading this market, we continue to advise caution,” said DataTrek founders Nichola Colas and Jessica Rabe.

“Clarity on Fed policy will not come until Wednesday’s FOMC meeting, and even then, commentary from the Fed and Chair Powell may be insufficient to calm investors.”

During the initial Covid crash in February 2020, the S&P gave investors a “head fake” when it rallied 10% from trough-to-peak after plunging over 15% in the 6 trading days prior. Many analysts thought the bottom had been reached.

But a few days later, the S&P retraced and fell another 30%. Does a similar fate await equities this time? It’s not out of the question. In fact, these types of “dead cat bounces” often occur in the middle of prolonged selloffs. Bulls just can’t seem to help themselves when they see a sizable dip.

And usually, that dip buying works out. When it doesn’t, however, it only contributes to additional pain once those bulls eventually capitulate.

For that reason, buying into the teeth of the current dip may not be the wisest move, tempting as it may seem. Traders might at the very least want to wait until Fed Chairman Jerome Powell’s post-FOMC press conference tomorrow afternoon, which is shaping up to be a true “make or break” moment for stocks.