Examining a Sample Trade
Chapter 9: Timing in the Real World: Examining a Sample Trade
It was looking as if the economy was starting to buckle under the weight of the higher oil prices. This was significantly important because every U.S.
recession since the 1970s had been preceded by an oil shock. And oil prices at $138 per barrel and retail gasoline at $4 per gallon surely could be called an oil shock. There was clearly a connection between the stock market’s negative action and the economic data.
Following any sell-off, such as the one on June 6, three possible scenarios exist:
✓ A major break in the prevalent trend is near, or has already happened.
✓ The market can move sideways.
✓ A short-term correction in the primary trend is unfolding, and by being patient you may be able to establish a position in the dominant trend at a better price.
The problem is that you really don’t know which way things are going to go. In this case, the dominant trend prior to the sell-off was up. Knowing the trend that was in place prior to the selling, and with these three possibilities in mind, I started to look at some charts in order to formulate a plan.
Charting your way to the next step
Pay close attention to your charts when you notice a clear connection between economic data and price action in the stock market. Your three major goals are
✓ Analyzing the situation. Combine your knowledge of technical and fundamental analyses with the psychology of a market in the midst of what’s happening in the market.
✓ Designing a trading strategy. Based on your analyses, design a well- crafted, step-by-step, careful plan that either makes you some money or gets you out of the position with as little damage as possible if you’re wrong or the market turns against you.
✓ Putting the plan into action. Make the trade, establish the position, and then manage it as you take the plunge into chaos.
Getting the long-term picture
When doing your technical homework, start with a long-term view of the market. Figure 9-1 gives you a good long-term picture of the market. This is a weekly chart, which means that the action is compressed more than you’d see in a daily chart. This is the kind of chart that I looked at over the weekend after June 6. And here’s what the chart in figure told me:
✓ The S&P 500 had been in a bear market since October 2007. That made sense from both the fundamental and technical standpoints. The subprime mortgage crisis was just a few months old in June, and eco- nomic time bombs were going off everywhere, with bank earnings falling and housing foreclosures mounting. The U.S. employment picture was getting worse, and the Federal Reserve had its hands tied with regard to lowering interest rates because the dollar was very weak.
✓ The rally in the S&P 500 that started in March was clearly a bear- market rally that had failed in late May. The rally started as the S&P 500 found support at its 200-period moving average after losing some 20 percent of its value in about five months. After the media got all excited about the S&P 500 falling 20 percent and being in a bear market, the market rallied in March, but only long enough to grab headlines and get the hype going about the end of the bear market. All that added up to the S&P 500 failing to rally above its 50-period moving average.
Weekly charts use different parameters for moving averages. In this section, I describe them generically by using the term period. What’s important is that the S&P 500 found support and resistance at these key moving averages on a long-term chart. The longer the support and resistance level, the more impor- tant the break above or below this area.
My first analysis was that the market’s long-term trend was still down and that the Friday sell-off was more than likely a reassertion of the down trend.
My first impression was that I should look to go short at the earliest opportu- nity, unless the market could convince me otherwise.
Viewing the intermediate term
As I moved along in my analysis, I wanted to prove or disprove my initial impression. In Figure 9-2, I was looking to see whether I was right or wrong in my first run through the charts. Fundamental aspects of the economy (rising levels of unemployment and rising oil prices) were less than rosy during this period. So I had two votes for going short.
I dove into more coffee and looked at a four-month chart. This one showed me a failure at the 200-day moving average by the S&P 500 in May. The failure was fully confirmed by weakness in the RSI and MACD oscillators. (Turn to Chapter 7 to find out more about RSI and MACD oscillators.)
After the May failure, the S&P drifted lower (Figure 9-2) as oil prices contin- ued to climb. Yet the circled area in Figure 9-3 shows that two days of panic in the oil market, combined with bad economic data, was enough to trip the S&P 500 below its 200-day moving average. That was another vote for selling the market short. And now I had three, which meant that I had enough evi- dence to move on to the next step, executing the trade.
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Chapter 9: Timing in the Real World: Examining a Sample Trade
Figure 9-1:
The S&P 500 bear market started in October 2007.
Bear market starts in October 2007.
Start of bear market rally as S&P 500 finds support at 200- period moving average.
Failure of bear market
rally at 50-period moving average.
Chart courtesy of StockCharts.com.
Make sure that reliable oscillators confirm your moving average and trend analysis. I used the RSI and MACD oscillators. For more on these two useful oscillators visit Chapter 7. The RSI and MACD oscillators are important indica- tors that can be both early warning systems as well as confirmatory evidence.
In this case, they both came in handy by helping me to spot the overall nega- tive trend in the S&P 500, in both my long- and my intermediate-term analysis.
Figure 9-2:
The S&P 500 breaks down as bad news from rising oil prices and rising unemploy-
ment appeared on the scene.
1260 support area on the S&P 500 Failure at 200-day
moving average.
RSI rolls over.
MACD delivers negative cross over.
Bollinger band becomes greasy slope for stocks.
Worse then expected selling on employment report.
Chart courtesy of StockCharts.com.
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Chapter 9: Timing in the Real World: Examining a Sample Trade
Figure 9-3:
The S&P 500 dips below its 200-day moving average.
Two days of panic in the oil market.
Chart courtesy of StockCharts.com
Getting Ready to Trade
By Monday morning, June 9, I was ready to short the market. I had taken a big chunk of money out of the market on Friday and had secured the other long positions by placing sell stops under them. And I had some money in energy, in a gasoline futures ETF. I felt as if I were in fairly good shape, all things considered.
Now I was looking for the setup, the right opportunity to pull the trigger and make the trade.
I like to use the ProShares Ultra Short S&P 500 ETF to short the market, because it gives me twice as much of a move as the Short S&P 500 Shares (SH), the one-to-one ratio ETF that also shorts the S&P 500. Although I’m not flawless in picking when to short sell the market, it’s a totally different experi- ence than going long, and I’ve found, that for me, using the leverage works better.
Short selling is more volatile than going long. Instead of trying to hold on for a long period of time, I go for as much of a gain as possible in the shortest term possible. This is a high-risk strategy and one that sometimes leads me to sell too early. But I really don’t mind, because if I have a 20 percent paper profit that turns into a 5 percent loss in two days because I got greedy, I’m going to be very upset.
When I sell short, I’m looking to use leverage, as that lets me get more of a down market in a short period of time.
Looking for the right opportunity
A big part of timing the markets is the trading plan. I recommend the follow- ing three major aspects of a trading plan that have worked well for me:
✓ Define the major trend. The trend in Figure 9-2 was clearly to the down side, and I had decided to sell the market short.
✓ Use the right timing vehicle. You want the path of least resistance and the most chance at a good return in as short a time as possible.
✓ Manage the trade well. Find a good entry point to the market and set up some rules as to what you’ll do if things go right (or wrong). Make sure you have an exit strategy.
Following my trading plan, I went into Monday looking to short the S&P 500. I had my trading vehicle picked out — the ProShares Ultra Short ETF (SDS) — and I had a fairly good idea that I wanted to enter early in the day, especially if the market was quiet.
I had also decided that I would stay on the short side as long as the overall trend was fairly smooth but that I would look to get out if volatility picked up, and that I would use a fairly tight trend line to keep me in line. See Figure 9-4 for my trend line on SDS.
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Chapter 9: Timing in the Real World: Examining a Sample Trade
Figure 9-4:
Portrait of a successful short sale of the S&P 500 via the ProShares Ultra Short S&P 500 ETF (SDS).
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Bought on breakout.
Sold on pullback from Bollinger band and oversold RSI.
Trend line break signals end of up trend.
MACD histogram was losing stregnth.
Chart courtesy of StockCharts.com.
Tracking the trade
The stock market was fairly quiet on June 9, at least in the early going, as oil prices pulled back and the stock market took a wait-and-see attitude. That oil was quiet was no surprise; it had moved quite a long way in a very short time.
Things were developing according to my plan, so I bought SDS at $60.45 (the buy point shown in Figure 9-4). I bought in on a quiet Monday but above the breakout point on SDS. I was looking for strength; by buying SDS, which sells the market short, I was actually betting against the market rising.
By June 10, oil started moving higher and became more volatile. A key eco- nomic report, the IBD/Tripp consumer confidence poll, which doesn’t get as much publicity as other polls but can move the market, showed more weakness. The S&P started to move lower and gathered steam, falling farther below its 200-day moving average.
There was nothing to do but watch. That can be the toughest part of timing, that after you establish your position you become a spectator. The trade is now out of your hands, and your money is at the mercy of the market until you decide to do something about it. This spectator period is why you want to have some rules in place to help you manage the situation and to prevent you from getting antsy and making ill-advised moves such as selling too early.
Fine-tuning your exit point as things progress
By June 11, the S&P 500 had broken below 1350, and I started to look for the bump in the road because things were getting a little too comfortable.
Whenever I get too cozy in a trade, I get uneasy. And I was starting to get uneasy with this one just two days into it. The market was slicing through support levels like the proverbial hot knife through butter.
I started looking at the charts and found that the 1260 area in the S&P 500 had been support and resistance in the past and therefore was a point to watch: Markets retrace prior moves, which is what was happening here. The S&P 500 wasn’t going to hit 1260 anytime soon — it was down the road about 90 points from where the market had closed on the previous day — but this number became my make-or-break target. The market clearly was going to test it at some point in the future, and it was close enough to the bottom of the trading range that volatility would likely start as prices neared the price area. In other words, I was going to probably start selling this position as the market closed in on it.
The trade progressed well, as Figures 9-2 and 9-3 show. And, just as I expected, when the S&P 500 got to the 1260 area, it started to show some volatility. Instead of going straight down, it started to jump up and down, and in fact, started to act as if it were forming a base.
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The media was going crazy, and so was the price of oil. During this period, the oil market was so volatile that I appeared on CNBC twice — on June 4 and again on July 23. For them to call me back so often meant that they were look- ing for a bit of an “outside the box” presence as they tried to help viewers make sense of things. I’m not quite a Wall Street guy, as you’ve probably fig- ured out by now. CNBC’s interest told me that this might be an extraordinary period of time and that caution was the best policy.
The more the market moved up and down near 1260, the more uncomfortable I became. And on July 8, I sold my position in SDS at $70.06, for a nice 15.89 percent profit. I continued to watch the market, in case I had made a mistake.
Because the market seemed to be starting to break below the 1260 area, I thought I had made a mistake, and I bought back in a couple of days later, with a smaller amount of money. But I put a very tight stop on my position and when the market finally turned, a few days after my original sale of SDS, I was stopped out, with a small — less than 1 percent — loss, still netting me about a 15 percent profit for the whole trade.
When prices fall below key support, such as the 50- or 200-day line, the former support level then becomes resistance. After July 10, the S&P 500 started to move lower, seeming to use the lower Bollinger band (Figure 9-2) as a greasy slope. When you’re short the market, you want to see prices walking down the Bollinger band — a sign that sellers have an easy time, and that to go against the grain is a bad idea. As long as this was evident, I stayed short.
Reviewing your timing endeavor
In this trade, I bought an ETF that specializes in short selling the S&P 500 for a month. I made a 15 percent profit during this period. And I did it by paying attention to both the fundamental and technical aspects of the market.
Successful timing doesn’t happen because you do what you want to do. It happens when you find answers in the charts and in the fundamental data, and then act on the information with a well-crafted trading plan.
Here are some key questions to ask yourself after a trade, whether you make money or not:
✓ Was my pre-trade analysis sound? Three important aspects of pre-trade analysis make good guidelines for all your trades:
• Look at long-term charts to get a good idea where the major trend is headed.
• Shorten your time horizon to pick an ideal entry point into the trade.
• Match the fundamentals to the charts so you can confirm that your trade has the best chance of succeeding.
✓ Was my trading plan sound? Any trading plan worth keeping holds up in real time, so keep these points in mind:
• Take care of any open positions that may suffer when the market turns against you.
• If you have time to make decisions, use it — after you’ve protected your open positions. A weekend can be useful.
• When you’ve had a good opportunity to look at the situation and you know that you’re leaving as little as possible to chance, exe- cute the trade.
✓ Was the trade well executed and managed? You always want to give yourself the best chance to succeed. Thus, if you can enter the market during a pause that doesn’t change the overall trend, take the opportu- nity. If you enter a trade well, you’re already feeling positive about the situation, and your state of mind is relaxed. This allows you to think clearly and continue to manage the trade.
If you start to become uncomfortable with the trade, and you have a decent profit, it’s a sign that some profit-taking is the right thing to do.
A trading plan is a part of any timing strategy. After you come up with a plan, you need to review it every time you make a trade. That’s how you get better at timing. Turn to Chapters 2 and 3 to find out more about building and revis- ing your trading plan.
Finding a Sequence for Successful Trading
The trade that I outline in this chapter is a good representation of what you should be able to accomplish if you follow the methods outlined in this book.
Yet, note that analyzing and executing successful trades follows a definite sequence:
1. Address potential problems.
Review any open positions that you have that may be harmed by market events.
2. Analyze the market’s trend and your options for capitalizing on it.
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Chapter 9: Timing in the Real World: Examining a Sample Trade
Look into buying stocks if the trend is up, short selling if the trend is down, or staying in cash and not trading at all if there is too much volatility.
3. Make sure that the fundamentals and the technical aspects of the market are pointing in the same direction.
Ask questions, such as, “Is the economy sending bad signals at the same time that the market is selling off?” If the answer is yes, then the eco- nomic data and the charts are telling the same story, and your chances for success improve significantly.
In other words, timing is as much preparation, recognition, and the execution and management of the trade as it is about the tools that you use. You can make trading as simple or as sophisticated as you want, but in the end, the only thing that counts is whether you make or lose money. And if you lose and don’t learn from the experience, you pay for it over and over again.