The Max Pain Trade Is…

If one market analyst is to be believed, the path of the market that will lead to most pain will involve a move higher from the early August lows followed by a sharp correction in September and October, repeating a pattern not seen since 1998.

Back then July marked the high and October the low, much like it did this year at least when it comes to the highs. If the second stage is to occur, it will need to end with a big price correction into September and October after the most recent bounce.

Traditionally, the August and September timeframes are among the weakest all year for the market but in Presidential Election years, the market can remain shaky all the way through to October.

So, what’s the best way to play it?

Key Points

• A potential market rally from August lows may lead to a sharp correction in September and October, echoing the 1998 pattern.
• August to October is historically volatile, with increased risk during Presidential Election years.
• Hedge positions, consider short-term treasury bills, and be wary of limited opportunities in equities.

The Market Pendulum Swings

No doubt when you first entered the market, you fell victim to buying the high and selling the low. As time went by, with a little learning and luck, you learned how to invert that and buy the fear more than the greed and sell the greed more than the fear.

You can think of the market pendulum swinging back and forth, creating maximum pain for the most emotional of traders. Those who get excited near the peaks buy it, and end up losing. So too, those that get most scared near the lows, sell, and miss all the upside.

As you observe the market, it’s always worth asking what trend now would lead to most pain? Or in other words, what direction would the market have to move in order for those most susceptible to emotional trading to make the worst decisions, based on fear and greed rather than rational.

According to one top analyst, a move up from the August lows will lull most into thinking that the early August plunge was simply a dip to be bought.

As they jump into new positions expecting the worst to be behind them and talk of Santa Claus rallies ahead, the market that will lead to the most pain for them will be a sharp downtrending one in September and October, right after they have established their positions.

So, how do you play the “max pain” trends to come, if they do indeed come to fruition?

How To Play Max Pain Scenario

First off, don’t forget about three and six month treasury bills when the end of the month arrives. It may be boring to lock in a 5% yield but there is a lot of solace and comfort that comes from watching your invested principal clock higher each week, especially when the market is crashing.

In the meantime, it’s worth paying close attention to what appears to be a narrowing window for equity bulls. While there is still runway left to climb higher, it’s noteworthy that many champion traders now from Mark Minervini to Oliver Kell have all made similar comments about how few opportunities they are finding.

Not many stocks now are signaling a breakout or a compelling high volume, high price follow-through. That being the case, be wary of getting overly bullish, consider hedging into September, and watch out for a sharp U-turn in the market if skittish sentiment creeps into it.

If everyone cottons on to the max pain trend, the odds are the market will punish the shorts, hedged positions, and bears more so than the bulls, but either way if you have some allocation to short-term bills like Buffett, you won’t go too far wrong at a time when seasonal risk is elevated.