Trading Nation

If stocks fall below the ‘Mendoza line,’ watch out!

Is stock picking back?

Stocks are enjoying a strong Wednesday, with the rising to levels not seen since the sharp mid-August decline. And the key now, says one trader, is for the large-cap index to stay above a critical level.

With the S&P near 2,080, "I'd look at 2,000 as your bull/bear line on the downside," said Phillip Streible, senior market strategist with RJO Futures.

While round-number analysis can sometimes seem a simplistic or even silly way of looking at stocks, levels like 2,000 can truly matter as long as sufficient weight is attached to them.

"It seems like a lot of people are using that number as a benchmark," Streible said. "People will say, 'Hey, the world's good, we're over 2,000,' or 'Buy the 2,000 puts — if we go below there, we're going to hell in a handbasket!"

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That is, in order to get protection on stocks, individuals will simply buy a position that will show returns if the S&P 500 falls below 2,000 within a given time frame. Indeed, the put contract expiring in December with a strike price of 2,000 is the most widely held option expiring in 2015, and can currently be purchased for about 1 percent of the price of the index.

The thought among those trading stocks that such a critical level exists actually has a parallel in America's other favorite pastime: Baseball.

Mario Mendoza, a shortstop who played for the Pittsburgh Pirates, Seattle Mariners and Texas Rangers in the 1970s and early 1980s, was known as a good fielder but weak hitter. With a career average batting average of .215, he struggled to stay about .200. This figure has become known as the batting average separating decent hitting (such as would allow a manager to keep an excellent fielder in a lineup) from true offensive incompetence.

Even though the average batting average varies from year to year and from team to team, if a hitter falls below the so-called Mendoza line of .200, he is generally in trouble.

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Similarly, the 2,000 level on the S&P is where market participants will change their minds about stocks, determining that they are in bad shape — which threatens to become a self-fulfilling prophesy that will lead to the actual acceleration of losses, said Streible.

"That is the level we keep testing," he said in a Tuesday "Trading Nation" segment. "If we come back below 2,000, the market should continue going lower."