Breakeven levels can guide stock index traders

It is my belief that the long-term direction of the equity market is driven by:

  1. The ability of stocks to meet earnings expectations
  2. The competition that those earnings receive from other investment alternatives (predominantly interest rates) for the investment dollar
  3. And the amount of capital available to chase these investment alternatives.

However, on a day to day basis, market direction is driven by momentum, technical (support and resistance) factors and market psychology, with the intermediate variables listed above as an additional tail/headwind. It is beneficial for an investor/trader to understand which playing field his interest lie. From a technical perspective, traders are cognizant of the psychological importance of recent price Highs and Lows as key resistance/support levels. Another technical level, which is important, but not nearly as well known or discussed, is levels which represent breakeven points for traders and money managers.

For an example of their psychological impact, suppose you are a money manager. Your charter is to outperform the S&P, and you receive X dollars on a Friday to invest in equities, or an index of stocks. Reluctant to expose your purchase to untradeable events over the weekend, you decide to wait until Monday morning to put the new money to work. The market opens up modestly on Monday, say 0.5%. You are determined to invest the new cash by the end of the day, as it is not your mandate to draw Treasury Bill yields. You don't want to chase the market, but when the market pulls back to breakeven, you, the money manager, cease the second opportunity to put the money to work at Friday's Close. On this fictional morning of trading, there would likely be other money managers and traders with the same mindset, so given the market does not have other recently acquired information to drive it back through the previous day's Close, the market tends to find support at the previous session's Close after an up opening. Then each repeat retest of the level increases the odds, the level will be broken. 'If the support level doesn't provide a bounce, your Long could soon get trounced' - Johnny Cochran.

This applies for traders as well. Suppose that you are a short-term Bull, who refuses to carry positions over the weekend. You cover your Longs on Friday's Close, looking to put them back on when trading resumes on Monday. When the market opens higher Monday morning or Sunday night, you begin looking for an entry point. When the market pulls back to breakeven, you have the opportunity to resume the position you took off on Friday with no missed opportunity expense, which is psychologically appealing. This applies especially to Mondays, since it comes after a two day gap in trading, but also on any other day. One of the intraday trading rules in a beginning 'Trading 101' or 'Trading for Dummies' book is:

  1. If the market opens up, buy any pullback to the previous day's close.
  2. If the market opens lower, sell any rally back the previous day's close.
  3. And put your stop x% below/above the previous day's close.
  4. If the market retest the previous day's close twice, cover the position.
  5. If the market retest the level three times, reverse your initial position.

Why do I bring this up today? I was reminded of its significance by yesterday's trading activity which supported the idea that breakevens can play a role in support/resistance on an intramonth basis as well. There is a similar breakeven psychology at work at the monthly level as well, as many money managers receive new investment capital at the beginning of each month. If the month starts out with weakness, the manager may decide to make friends with the sideline until motivated to do otherwise. Often, the market trades lower all month and the manager is rewarded for his patience, but if the market rallies back to breakeven at some point midmonth, the manager, whose mandate is to outperform the market, is now enticed to put the money to work, contributing additionally to the upside move, and putting in place the potential for what I call a 'Breakeven Breakout'. However if the market can't take out the previous month's Close, the tendency is for the market to fade on the retest attempt.

The S&P closed out April at 1363.61 and then proceeded to post four straight daily losses to start the month. Yesterday (May 10), the S&P had retraced 90% of May's losses and traded (1359.44) within four S&P points of the April High before closing the day at 1357.16. One day later, we are now 21.53 points or 1.6% below the April Close and the potential for an intramonth 'Breakeven Breakout' above 1363.61 is fading.

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