The high-yield sector broke down last week. And then… it didn’t.
Let me explain…
Last Monday I told you to keep an eye on the high-yield sector (HYG). The daily and weekly charts of HYG were on the verge of breaking down from bearish rising wedge patterns. And, since the high-yield sector typically leads the broad stock market by anywhere from a few days to a couple of weeks, a breakdown in HYG would be a big warning sign for the stock market.
Junk bonds rallied a bit to start the week. But on Tuesday and Wednesday, HYG dropped 1%. That’s not a big move for a stock, but it’s a HUGE move for a bond fund. And it was enough of a move to cause HYG to break down from the rising wedge pattern on the daily chart. Take a look…
HYG broke below the rising support line of the wedge pattern (the solid blue line). It broke below the support of its 9-day exponential moving average (the red line). And it fell all the way down to its 50-day moving average (the thin blue line).
By Wednesday, it was obvious the high-yield sector was breaking down. And analysts started jumping on board the trade. Firms like Bank of America downgraded the high-yield sector. Big-name market gurus warned of the potential collapse in the junk bond market. Even the talking heads on the financial news networks were talking about it – and they hardly ever mention junk bonds.
That made me worry. But not in the way you might think.
You see, my Delta Report subscribers owned put options on HYG going into last week. I was confident the sector would break down. The action in HYG on Tuesday and Wednesday justified my confidence.
But, after more than three decades of playing this game, I’ve learned that whenever everyone else – especially the financial media – agrees with my opinion, my opinion is likely to be wrong. At least in the short term.
So, I told subscribers to take advantage of Wednesday’s decline in the high-yield sector and sell half of their HYG put options for a 100% profit. Then we set a stop price on the other half to ensure a gain on that position. HYG was approaching its 50-day MA. It was likely to try to bounce off that level.
While the momentum was bearish, I was concerned that with so many folks suddenly drawing attention to that bearishness, the market might be getting ready to whip the bears.
That’s what happened on Friday.
Go back and look at the chart. HYG bounced hard off its 50-day moving average (MA). It recovered more than half of what it lost on Tuesday and Wednesday. And, it closed above its 9-day exponential moving average (EMA) – thereby shifting the short-term momentum back to bullish.
We stopped out of our remaining HYG put options on Friday, for a small profit on that half of the trade. All in all, my subscribers recorded a 70% gain on HYG put options in just nine days. That’s a terrific return.
But I’m not satisfied. There’s a lot more downside potential in HYG.
Friday’s miraculous recovery in the high-yield sector has turned the short-term momentum bullish. And it prevented the weekly chart from breaking down from its bearish rising wedge pattern. Here’s a look at that chart…
HYG sure looks like it’s on the verge of breaking down from this weekly pattern. But it’s going to take a decisive close below its 9-week EMA (the red line) to do that. In other words, HYG needs to end this week below $87.87.
Until that happens, we can’t rule out one more push higher for the high-yield sector. HYG could run back up toward the resistance line on the weekly wedge at about $88.75. That would certainly punish the folks who got overly bearish on the sector last Wednesday.
But that sort of a move would also set up another low-risk entry point for short positions.
So, here’s the bottom line…
The high-yield sector didn’t quite break down last week… but it’s still on the verge of a significant change in momentum.
If HYG declines this week and causes the weekly chart to close below its 9-day EMA, then be careful. Stocks are likely to follow.
On the other hand, if HYG rallies this week and the chart climbs back up toward the resistance line of its rising wedge pattern, traders can look to establish low-risk short positions in the junk bond market.
Best regards and good trading,
P.S. It’s been great to hear from subscribers of both the Market Minute and Delta Report. If you have any questions, insights, or great trading stories, send them right here.