"Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory in relation to the foe whom he is facing. Therefore, just as water retains no constant shape, so in warfare there are no constant conditions."
-
Sun Tzu

Tuesday, March 29, 2011

Practical Swing Trading: THEORETICALLY Swing Trading is Easy

Theoretically, swing trading is easy: you buy the short-term pullback of a trending stock and sell into the new heights. I like this approach because it makes so much sense to me: to buy when others are selling and sell when the crowd is buying. Swing trading is in essence the application of two market inefficiencies, which can be statistically verified: momentum and mean-reversion. A broader discussion of these topics will probably be subject of a later post.

Unfortunately, swing trading sounds easy on paper, but there are a lot of nuts and bolts to it. But before discussing what could go wrong, let's look at a recent textbook example: Lululemon Athletica (NASDAQ: LULU). The stock gained 8.4 percent yesterday, according to stockcharts.com. So if you were a swing trader, should you have bought the stock at the close?

Let's discuss the recent price chart:


I like to keep it simple, so I do not use many indicators. Just two moving averages to define the trend, moving average envelopes to indicate the areas of "maximum optimism" where I should sell and relative strength vs. the S&P 500. The later one is my most important decision tool. Remember, we need to buy momentum and a stock that can resist negative market action is likely to show strength when the market goes up. Again, LULU is the perfect example.

In the last five months, LULU offered three swing opportunities, where the stock pulled back to its 20 day moving average while relative strength was rising: end of November, end of January and at the beginning of March. Not that I usually do not like to buy the first bounce. Instead I prefer to wait for a successful re-test of the swing low.

The sell points were also clear from the chart: when prices touched the upper channel boundary, it was time to sell. Remember, swing trading means to "buy the dip and sell the rip".

Let's take a look at the recent "buy signal": obviously, yesterday's close would have been too late to get in. There were a lot of good opportunities to buy the swing in the last weeks. At this point however, a swing trader is already looking for a good price to exit. The question is if LULU will experience volatility expansion, something, which can be better visualized using Bollinger Bands. In that case, a swing trader would simply hold the stock as long as price "walks the upper band".

I mentioned that swing trading is easy - THEORETICALLY. The recent LULU buy signal is one example of why this trading style might be not so easy to realize for most people. You needed to buy LULU in the first weeks of March, a time when very negative headlines dominated the news - Japan earthquake, Egypt, Libya, rising oil, end of QE2, etc. In addition, Jim Cramer was telling you to sell into strength and prepare for lower prices ahead. In order to be a successful swing trader, you need to blend out that noise. In my experience, not many people are capable of doing that and go against major headlines. Trading books didn't tell you that, did they?

On a final note: did I take the recent LULU trade? No I didn't. The stock was on my priority 1 watchlist, but so were others, such as BIDU, SGI or BX, which I currently own. I cannot trade everything. Maybe one day, if I'm a hedge fund, I might  be able to do so. :-)

Thursday, March 24, 2011

Short-term Market Direction: Watch Dr. Copper

Dr. Copper had a pretty good track record recently when it comes to front running the S&P 500 in the short-term. So it will be interesting to see if the recent strength can translate into higher stock prices as well. Note how Copper is about to break its short-term downtrend while the stock index still needs to make up a couple of points before being in the same position:

COT Divergences

I recently did some work on COT data divergences. My thesis is that when large Futures traders ("Smart Money") become less bullish despite a runup in prices, it ultimatly leads to a breakdown.  I found that these divergences take quite some time to develop, so I usually look at weekly charts (www.timingcharts.com).  Even when they occure, prices can run for weeks of months. I would combine COT data analysis with other technical and breadth tools to get a better picture of the markets.

Here are some recent examples:

Dollar Index:


Note how the 2010 Dollar rally was not supported by an increase in long Futures contracts. Ultimately, the Dollar reversed.

Crude:


This one is interesting: the final push during the 2007/08 rally above $110 was not supported by large traders. Again: the smart guys sold into strength.

The S&P:


A strong divergence occurred during the recent rally: large trades didn't buy it. Note how they turned net short in January. The "Smart Money" was right.

Gold and Silver:



The latest rally was not supported by an expansion of long positions in the futures markets. Unfortunately, I'm currently long Silver, so I take the divergence as a warning sign and will start scaling out of the trade earlier than initially planned.

Wednesday, March 23, 2011

Crude: COT at Multi-Year High

It is quite amazing to observe what is currently going on in the Futures market: based on the "Commitment of Traders" (COT) data, a record amount of large speculators is currently long Crude. Over 250,000 contracts are held long, according to the latest report, which is a multi-year high. Traders seem to be even more bullish than three years ago when Oil was trading at $140:


So what does that mean for the future price of Oil? Numerous quantitative studies have been carried out on the topic of COT-based price prediction, without consistent success to my knowledge.

To me, it seems to make most sense to look for divergences and follow the "smart money" (the large speculators). However, I haven't quantified the strategy yet. Some andectotal event: divergences developed prior to the top in Crude prices in July 2008 (see chart).

Interpreting the current reading is difficult, since there was no similar event in the last 30 years. Current readings are simply "off-the charts":

 Intuitivly, I would say that extreme readings are bearish, because everybody is leaning to one side. In any case, it's worthwhile to keep monitoring the situation.

Tuesday, March 22, 2011

Germany's Exit from Nuclear Energy - Implications

Germany is the only industrialized country, as far as I know, who decided to exit nuclear energy. This morning, I was reading an interesting article in Germany's leading economic magazine "Wirtschaftswoche". There is a lot of false information out there about the topic, but a conservative economic media outlet should have some credibility. Here is a summary of the major points from the article:
  • In 2000, Germany made the decision to shut down all 17 nuclear power plants until 2022 (BTW: it was not Angela Merkel, who pushed that decision. SPD's Gerhard Schroeder negotiated the deal with the nuclear industry)
  • Germany now plans to immediatly shut down 8 of the oldest plants. Blackouts are not to be expected since the countries runs huge overcapacities.
  • While exiting nuclear power, Germany wants to increase renewable energy generation share to 20% until 2020 to replace the plants.
  • 20% renewable energy is only achivable by building giantic offshore windfarms and huge new powerlines throughout the country to distribute the energy from the wind areas in the north to south.
  • Electricity prices will rise by 20% until 2020 as a result of the nuclear shutdowns and investments in renewable energies (Remark: I'm more than happy to pay that price)
  •  After 2020, electricity prices are supposed to decline on a absolute and relative basis, because commodity costs for oil and coal will probably rise due to limited supply. Renewable costs should
    decline as a result of better technologies.
  • The longer term vision of the German government is to go 100% renewable until 2050.
These are great goals and I am proud that my country is capable of crafting and realizing these long-term plans. Right as well as left wing parties are supporting the plan (in fact, the lefties want to go even faster).

Wednesday, March 16, 2011

March 15 2011: Review of an Interesting Trading Day

Tuesday, Mach 15 2011 was definitely one of the more interesting trading days of the last years. I am trading short-term since 2007 and it took me all these years to learn how to handle sell-off days. On such a day, you can loose or win a lot of money. My portfolio gained a little, 1.4% to be specific.  Granted, the Financial Crisis was a great teacher in this respect. Years ago, I would probably have sold everything right at the open and even entered new short positions.

I went into the day with several shorts. It was clear that it would be too late to open new trades. The only question was when to take profits. Preparation is everything in speculation: Bespoke came out with a report before the open which surprisingly suggested the existence of a positive edge when going long right at the open. So I watched the first half hour of the market and stocks actually did not sell-off from in the first 30 minutes. I decided to close most of my short positions and take partial profits on the QID 2X QQQQ short.

It took me the last three years to learn that successful trading means doing what's not intuitive. Buying into a sell-off is exactly that (Buying blindly however is not what I'm talking about.).

As the day developed, I saw that the market kept climbing higher. It didn't matter why. I didn't matter that a nuclear catastrophe was still on the table in Japan. Bulls were stronger than bears. So let's play with the bulls. Period. Trading can be that easy.

So in the afternoon, I was looking for more long exposure. Not much, but just to test the waters. I went over my watchlist (which takes me one hour each morning before the open to maintain it). CSX Corporation (NYSE: CSX) caught my eyes: great technicals, no exposure to Japan, and good relative strength during the sell-off: obviously, I wouldn't be the only one buying. I took a long position for a quick trade. Overall, the market is still caught in a downtrend and I expect that rallies will be sold. I don't think I will keep the stock for longer than a couple of days.

At the end of Tuesday, 35% of my portfolio is long, 9% is short and 56% is in cash. Negative news from Japan could pull the markets down again, so staying nimble is still extremly important. A quick look at my favorite sentiment indicator, the equity put/call ratio suggests that sentiment is not overly bearish yet (but close). I want to see total capitulation before going long more aggresivly. We aren't there yet:

Tuesday, March 15, 2011

Covestor Model Portfolio Commentary: Playing a Possible Crash Scenario

Finally, the stock market recognizes two things: a) economic weakness comes before certain companies can benefit from rebuilding efforts in Japan, b) things might be worse than the Japanese "hush-up" culture tried to suggest. Futures are down 2.8% this morning and here is how I plan to steer the Covestor Model Portfolio through a possible crash scenario.


The first question: should weakness be bought? In my opinion, the only reason to enter a buy order at this point is to close short positions. Opening new short positions also doesn't make sense, since a snapback rally is a possible scenario, so new shorts only make sense for a day trade.  Longer term, I see the S&P 500 declining to at least to the 1230 level (first Fibonacci retracement). If that does not happen today, it might in the weeks to come. If Tokio really would need to get evacuated (which is propably impossible), I would even look for lower levels.

Here is how I am positioned going into the Tuesday session:
Cash: 23%
Long: 22% (AAPL, ICO)
Short: 55% (QID, XLB, AA, AIG, PHM)

My playbook is to take profits on the short positions and monitor if the longs can hold up (relativly speaking). I am looking for a scenario similar to the "Flash Crash" on May 6 2010. Aggressive traders went long on that day to benefit from the three-day snapback. However, since volatility was so high, position size needed to be small. A less aggressive, yet profitable approach with a better risk-reward was to wait for the snapback and then enter short positions a week after the Flash Crash: 


In any case: its crutial to either stay nimble these days or not trade at all if you are not experienced with breakdown situations.

Monday, March 14, 2011

Market Commentary: Rising Volatility

The market obviously changed his character. The low-volatility uptrend of the last months has been replaced by increased daily ranges and a slow downtrend since the end of February:


This volatile, non-trending environment is usually difficult to trade. As a result, my Covestor model portfolio underperformed in the last week despite the fact that I carry a large cash position. One option would be to go completely into cash and wait for market conditions to improve.

Volatility has been moving higher for the last months, when measured by the daily Average True Range:




Uncertainty obviously had been on the rise since the beginning of 2011, it's not just a effect of recent events in Libya or Japan. Volatility can be a precursor to lower prices, as can be seen on the upper chart. The opposite can also be a hint: Note how volatility declined from July to September 2010 while stocks were in a bottoming process. So a declining ATR is one of the signs that would prompt me to become more bullish.

Another sign could be a major sell-off. Various measures show a lack of fear in the market (so far?). One of them is the equity put-call ratio. Note how we had been seeing readings above 0.7 for multiple days before a correction ended in the last two years. As of last Friday: we are nowhere near that level:


However, there is another way to look at the S&P. Note how the latest consolidation is shaping up very similar to what we saw in November 2010. Should the 1300 level hold, we could see the same price pattern. A break of the upper falling trend line would make me leaning to the long side. However, one major difference: recent volume action has been significantly more bearish (increased volume on down days):


The final question then is: what could lead the markets higher? I'm watching the consumer discretionary sector, which has been holding up quite well in recent days. The industry has in fact shown superior relative strength since February. Note how the sector was leading before December and then underperformed during the winter months. It's the nature of a bull market to show constant sector rotation:


A lot of mixed signs these days. Keep trading to a minimum and watch for the signs mentioned above. 

Friday, March 4, 2011

Practical Swing Trading #1: Introduction

Four years ago, I started a journey: I became a "swing trader". It was maybe the best time to learn this "investment" style - in a period of uncertainty and difficult markets, where all textbooks failed to apply. By the way, the worst period of time to learn trading was probably during the Internet Bubble, when stocks went up every day. Most traders from that time have been wiped out in the new millennium because they were conditioned to trade in a perfect world. If the world appears to be perfect, it usually is only for a short period. Believe it or not, I also went through such a transition: 2009 was a year where the markets switched from bear to bull and I underperformed in that period. However, I adopted my trading style and 2010 (and 2011 so far) have been very positive.

When I started swing trading, I did what probably every "couch trader" does: I read a lot. There are great books out there, but I haven't found a single one which really tells the complete story. Some of them are just teasers to sell the author's seminars. Still, it makes sense to read them, but you need to keep in mind that you will not be able to trade profitably after finishing these writings. Swing trading sounds easy in theory: you "buy the dip and sell the rip". Many books are showing perfect world chart examples, but when you want to start trading, you figure out that the real world looks different.

I learnt a lot in the last four years and put thousands of hours into this trading project. Through my own research, observations and mistakes I found the missing pieces that make short-term trading work for me. My trading account showed positive returns in every single year since I started this and overally outperformed the S&P 500 by a wide margin. (In fact, if you would have invested in a S&P 500 index fund four years ago, you would still be negative). Sometimes in life, luck meets hard work: I was one of the first members on the Covestor platform and I was therefore able to build a track record (absolute performance numbers for the intial years are not accurate, though, because Covestor initially didn't track cash positions). I feel that this gives me some credibility to write about my trading style.

So since I think there are pieces missing in many trading books, I decided to write a series of posts about the topic. I call this series "Practical Swing Trading" in reference to Victor Niederhoffers book "Practical Speculation", one of the must-reads in my opinion. It will take me months to write down all the things I have in mind and if I can do two posts per month, I should be finished by the end of the year.

I'm writing this primarily for myself. To structure, what I have learnt. I'm happy if somebody reads this and when he or she can get some new ideas and inspirations. I hate Wall Street and I believe that most mutual funds are not worth their money. I hate market commentators, who do not publish their track record and probably just make money by commentating and not by investing/trading. I'm therefore happy for everybody, who is able to manage his own money, outperform the markets and maybe outperform me.

The next post will give an overview of what I have in mind for this series and present a "table of contents".

Stay tuned

Tuesday, March 1, 2011

Market Commentary: Watch That 1300 Level

Today's bearish price action bakes the question "What's next?" The following chart shows, how critical the situation is - technically - for the S&P 500:


The index is still in an uptrend but rapidly approaching key support at 1300 again. The level is important because not only did the market find resistance in January and support in February, the S&P would also break the intermediate term trend line from September 2010. Now here is the key: we are all watching the same chart. How do you think investors would behave if the index indeed would close below the key level in the next days? Some would maybe pull out Fibonacci (blue lines) and determine next intermediate term support around 1230 - six percent below the current level. A rapid move down could be the consequence.
What makes the current situation even more delicate: the market experienced four "distribution days" (high volume declines) in the last four weeks (including today) - institutions are selling.
I'm not saying that markets will decline. Just outlining one possible scenario, based purely on technicals.