"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

Friday, September 30, 2011

Intraday Volatility Rising Again

Something has changed in the markets the last days. Intraday volatility, as measured by the 65 period (5 day) Average True Range, is on the rise again. To me, this means market participants are getting more nervous. Should this trend continue, I expect major indices will break out of their range soon. It's like a storm is gathering energy before the wind is starting to blow:

Thursday, September 29, 2011

Live Trade: SHORT FDX

I'm trying out something new: on an occational basis, I will highlight my (technical) rationale for individual trades. I will post right after I entered a position and provide updates in the following days on why I hold or closed the trade. These trades will be executed in my Covestor Model Portfolio and should give you a feel for how I buy and sell stocks.

Today, I shorted FDX. The stock is moving in a downtrend and has been underperforming the broader market for the last months. The trade is a play on the weakening global economy theme. Note that I usually try to identify driving themes and then select the appropriate stock/ETF to trade this theme. Here's FDX' chart when I shorted the stock this morning. Stay tuned for updates:

When Do I Sell?

I was recently asked to explain my selling methodology. Let me highlight a couple of points concerning this topic.

First of all, I can't fully discuss selling in a blog post since I could easily fill a book with content. However, I can give you an idea about my methodology. In fact, it is not really my proprietary method. A lot of the aspects are taken from Alexander Elder's approach. I strongly recommend studying his work if you feel that the concept makes sense to you. I recently discussed how his ideas influenced my trading here.

I am basically a "channel trader", who is using EMA channels to determine exit points. The idea is to sell when everybody wants to buy or vice versa in the case of a short trade. The concept makes so much sense to me since I believe that you can only make money on the stock market by buying low (which by definition is when everybody is selling) and selling high (which means selling when everybody is buying). In order to implement this concept with technical trading tools, you simply need a moving average and channels, which reflect a positive/negative increment to the current average price. So conceptually. I'm trying to buy close to the moving average and sell close to the upper channel boundary in the long case. In addtion, I often scale out of positions, especially in strong markets in order to let profits run.

Here are two recent trading examples:

I bought AMZN on August 26. The stock was trading close to the 20 day moving average. I sold the stock three days later when prices touched the upper channel line. As you can see, I took out only a portion of the entire move, but that's ok. That's swing trading. I'm not trying to sell at the absolute top.

Another example on the short side: FST.
I shorted the stock on August 8, again, close to the moving average, the level of "normalcy" (Elder calls it "value") if you will. FST moved down strongly and I reduced position size by half two days after I shorted the stock. I finally closed the trade two additional days later when downside momentum deteriorated.

As I mentioned before, there are a lot of nuts and bolts to this technique and I highly recommend reading Elder's book The New Sell & Sell Short for more details.

Note that I was showing you two successful examples here. In reality of course, not every trade is succesful. In fact, there is a lot of noise and randomness in the markets so many trades (between 40 and 50 percent) will not work out and you have to sell with a loss. No big deal if you have good money management, though.

Friday, September 23, 2011

Covestor Portfolio Update: What Happened During a Brutal Week

A quick update on what happened to the Covestor Model Portfolio after a brutal week for global equities. As I mentioned in my last monthly Covestor update, it was "time to focus on mean reversion trades": the S&P 500 has been in a trading range between 1100 and 1230 since the beginning of August. I have been trading the range with a bearish bias: going short at the top of the range, closing shorts and going modestly long at the lower levels. The strategy has worked out so far, the model portfolio is up almost nine percent for the month of September. It's a very short term oriented strategy and the trades barely lasted longer than three or four days. For example, I took various short positions last Tuesday (IWM, REMX, KOL, GS, VSI) and closed the trades fully (IWM, VSI) or partially yesterday (Thursday). The S&P closed at the lower end of the range. Does that mean it is time to go long again? I don't think so. However, adding to the shorts isn't a high probability trade either. Given the recent downside momentum, there is decent chance that stocks will build another leg down. In a highly volatile, news driven environment nasty short covering rallies can occur any time and it is mandatory to manage risk. I will keep raising cash if major indices continue to record new lows. My favorite scenario is a panic sell-off, because a reaction trade on the long side would offer a compelling risk-reward situation. Unfortunately, various sentiment indicators I'm following  indicate that fear is not at extreme levels yet, so keep your seat belts fastened.

Tuesday, September 13, 2011

Pair Trading Ideas

I like the idea of trading pairs in order to play secular industry trends while being  market neutral. So far, I don't trade them, but I might consider setting up a model portfolio in the future after some more research.

Here are some interesting pairs:

Long Amazon, short Best Buy:


Long Dollar General, short Wal-Mart:

Long Apple, short Nokia:

Long Germany, short Italy:

Monday, September 12, 2011

Covestor Portfolio Commentary - Coming Next: Dow 10,000?

Futures are down sharply this morning and stocks are a mess. Classical chart analysis suggests that the DOW could see a rapid move towards 10,000 within the next weeks. During August, a bearish "rising wedge" pattern shaped on the charts of various indices and a break of the lower pattern boundary, which we might see today, could move the Dow Jones to the next major support area around 10,000:

What does that mean for the Covestor Model Portfolio?
Last Friday, I closed all my long positions (most of them with a small loss) and opened various shorts when it became clear that the rally was over. In hindsight, it was not a wise decision to trade the rebound by buying into strong stocks. In bear markets , trading direction is SHORT, Period. The only exception is if markets experience capitulation and even then, going long requires a lot of experience and very conservative money management. So far, I haven't seen investors throwing in the towel, but that could change fast. Too many "momentum stocks" have been holding up quite well.

So going into the week of September 12, Covestor clients are short Italy (EWI), Financials (long SKF), First Solar (FSLR) and Netflix (NFLX). I keep the number of positions small in order to stay nimble. Correlation among stocks is high, so it saves time and commissions to focus on sector and country ETF's.
Should the markets indeed record new lows this week, I will gradually reduce short exposure and take profits into weakness.

Overall, I'm not sure if I should enjoy the latest developments because the Covestor Portfolio is doing well, or hope for a stronger market because my 401k is suffering. Unfortunately, the managers of the Fidelity funds I own haven't been able to record positive returns this year unlike me. I'm starting to ask myself why I still own them.

Wednesday, September 7, 2011

My Short Italy Position: a Classical Swing Trade

Yesterday, I partially covered my short position of the Italy country ETF EWI. So far, this trade has been a classical swing trade and represents the"bread and butter" trade in my playbook:

EWI has been moving in a perfect downtrend while underperforming even the US markets, represented by the  S&P 500 in the lower pane. The sell-offs came in on increased volume, a bearish sign. My general strategy is to sell short close to the declining moving average and cover when prices touch the channel boundaries, so yesterday was a day to take profits. However, I didn't close the entire position because downside momentum has been very strong in recent days. Price action today or tomorrow will determine if I finally will shut down the trade.

Disclosure: Covestor Model Portfolio is short EWI.

Monday, September 5, 2011

JOE: Potential Long Trade

There are not may stocks I'm considering candidates for a long trade these days, but JOE caught my eyes.

St. Joe is a stock I was shorting a couple of times during the first half of this year. Recently, I looked at its longer term chart again and believe it or not, the stock might  start to look like a long at this point. Let me explain:

When looking the price action the first time, one would say that the chart is mess: JOE is in a downtrend as defined by the declining 20 week EMA. Also, the stock has been underperforming the S&P 500 in the last five years, so there is no relative strength recognizable on the weekly chart.

What's intriguing, though, is that downside momentum is waning: the bears have been loosing steam in the last years, which can be seen by looking at the divergence of price and the MACD indicator.

Even more compelling is the volume action. The "Force Index" (basically result of price rate of change multiplied by volume change) also shows divergence: so volume on the downside is fading. The entire action is taking place at an important long term support level, $15.

Let's take a look at the daily chart:

Same divergences on the shorter time frame. The stock even slightly outperformed the S&P 500 over the last two months. I believe that somebody is buying here and the market doesn't notice yet because of current macroeconomic concerns.

What's even more compelling: JOE has a very high short ratio: it would take 32 days for the shorts to get out at the present volume, so the stock is a major short squeeze candidate.

I'm not pulling the trigger on this trade yet, but keep it on top of my watchlist for a potential turnaround play. All bets will be off  if price breaks $15 of course.

What a Trader can Learn from NASA's Apollo Program

(I apologize for the somehow geeky post, but sometimes the engineer in me comes through since aerodynamics was one of my majors at university :-) )

http://static2.businessinsider.com/image/4d90a8644bd7c8585d370000/rocket-failure.jpgThe other day I saw a fascinating documentary about the Apollo Moon program in the Sixties which reminded me of some important trading lesson.
During early development stages, rockets quite frequently blew up in the testing. Engineers got frustrated because there was intense pressure from Washington to move the program forward. According to Jesco von Puttkamer, who was one of the engineers, Werner von Braun was pretty cool about the failures. He kept saying that they were fine as long as they gained telemetry data during the test flights. These recordings helped them to find the source of the problems.  Ultimately, von Braun's team succeeded, of course.

Trading is similar: some trades will blow up, it's no big deal. As long as the trader knows why, he is fine. There are two reasons why a trade can fail: number one is by design, the other one is by mistake.

The "failure by design" is nothing to lose sleep over: no trading strategy has a 100% win rate. That number will be somewhere between 40 and 70% depending on the strategy.

"Failure by mistake" is an issue and something every trader, even me,  has to work on. Nobody is executing the perfect trade all the time, sometimes one is biased, sometimes one is not following his own trading rules. That's why it is extremely important to monitor one's trades as detailed as possible by writing a journal and collect "telemetry data" if you will.  

Most important, though, is to be relaxed about it, like Werner von Braun. He probably would have been a great stock trader as well, but since he was a genius he would have excelled in every field. Geniuses tend to be multi-talented.

Sunday, September 4, 2011

How Dr. Alexander Elder Inspired my Trading

My current summer read is "The New Sell and Sell Short" from Dr. Alexander Elder. I have read his earlier books, but this one is a great refresher and expands on the shorting topic. In this post, however, I do not want to discuss the book but rather highlight, which elements of Dr. Elder's philosophy I have adopted to my trading.

Overall I have to admit that probably 80% of my trading style is based on Elder's strategy. I tweaked his approach here and there to fit my view of the markets. In a nutshell, the Elder approach is a swing trading strategy that buys stocks at value when they are close to a moving average and sells when prices are extended, which means that the stock is trading at a distance to the average. Of course, there are a lot of nuts and bolts to it, and I encourage aspiring swing traders to study Elder's work. When I read his books, the approach immediately made a lot of sense to me: buying at value and selling when everybody wants to own a stock seemed to be so logical. Also, the strategy is in essence a mean-reversion approach. Mean-reversion is a market anomaly, which has been observed by academic research.

Here are some of the Elder tools I'm using:

  • Trading on multiple time frames: making strategic decisions on the weekly chart, tactical decisions on the daily.
  • EMA channels on the daily chart to define value and over/underpriced zones.
  • MACD indicator to evaluate when a trend is weakening
  • Elder's Force Index to indicate when bulls/bears are loosing power
  • New High/Lows to evaluate market breadth
  • Money management rule: Elder recommends 2% of capital per position. I'm using 1%, though with a different technique to calculate stop prices.
Some tools I'm using in addition to Elder:
  • Relative strength against an underlying index. I want to own stocks that act stronger than the overall market. Relative strength can also show early warning signs when divergences occur.
  • Equity put/call ratio for a look into overall sentiment.
  • A different scanning process. Elder is starting with industry groups and then boils down to individual stocks. I run technical trend scans and look at the chart of every S&P 500 stock twice a month to find stocks which match the patterns in my playbook (believe it or not, there are just five patterns in my playbook. Ten, if you add the short side. Out of the five patterns, there are two major ones that I actively trade, the other ones are either "niche" patterns or still in the "development phase".
  • Scaling out of positions: it seems like I'm using scaling much more actively than he does. However, I'm still fine tuning this technique. 
  • Modified risk and stop price calculation: since I'm trying to trade in the second half of the day and I'm not using hard stops, I need to incorporate the volatility into my risk calculation.
If you are looking at my standard daily charts, you can obviously find many Elder elements. Again, the major difference is probably the additional relative strength:

Note that I'm not using the Elder Impulse System, which is a different way of coloring the bars. Reason is that I want to limit myself in the number of indicators on the chart ("keep your chart clean") and I'm already at the maximum number of items that I feel comfortable with.

Overall, the Elder approach has greatly benefited my trading. Even though the strategy is relatively simple, it took me years to really learn it and to eliminate basic mistakes. Maybe that's the time it takes because there are many behaviors that need to sink in and become automatic in order to get constantly profitable. Even though I'm OK with my trading results, there is still room for improvement and there are several areas I'm currently working on.

Thursday, September 1, 2011

Why I Don't Like Gold Miners (Yet)

A fellow blogger recently commented on Gold Miners: J.C. Parets argued that stocks are poised for a breakout, based on technical conditions. I'm not (yet) optimistic for Gold stocks. A key parameter in my trading is relative strength and Miners have simply underperformed f Gold in the last months. One could argue that stocks are poised for a catch up move, but even in that case, the Gold Miners ETF, would outperform the yellow metal. Note how the last move in September 2010 was indeed accompanied by strength against Gold and the general market:

However, there is a positive sign today: GDX acted much stronger than the general market in recent weeks, so let's keep an eye on the GDX:GLD ratio to evaluate the quality of a potential breakout move. Frankly, there is no point in owning Miners if Gold is acting much stronger. In that case, own the metal instead.

Disclosure: Covestor Model Portfolio is long DGP.