The Many Ways to Play a Directional Turn January 28, 2011
Posted by smarttradepro in Current Issues.Tags: pointing to a market correction., stock market that is overbought, Ways to Play a Potential Market Drop
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Last week’s article on market extremes elicited several types of responses from readers. There were the very kind thanks for the insights (always appreciated on this end!). There were references to others who had similar opinions (thanks for the insights!). And lastly there were the requests for how to play the potential drop in the equities markets from these lofty heights.
In response to those requests, I have to remind everyone that Tharp’s Thoughts is not a trading recommendation newsletter. On occasion, we present research intended to provide insight into current market conditions that could help traders and investors formulate trading ideas. Providing individual trade recommendations, however, is outside the scope of our purposes for writing here.
With that said, I thought it would be instructive to present several possible ways to play this potential market-topping action. Let’s look at some different ways that a trader might express that the idea of a potential correction. First, let’s review where we are.
This Market Is Technically Stretched
Last week, we looked at a couple of factors that pointed toward a stock market that is overbought and due for a correction. One of these indicators is the chart from last week that showed accelerating price activity.
Since last Tuesday, one market maven has told me, “General market activity has kicked another leg out from under the stool,” meaning that even more elements are pointing to a market correction. First is the general retreat of the commodity complex where most of the major dollar-denominated commodities (gold, oil, etc.) continue to head down.
And as we see in the chart below, acceleration lines are being broken and the subsequent rebound has yet to reach new highs.
Last week I said that one could play this potential market-topping activity by trading the correction. If that correction failed to materialize, you could reverse and play the breakout.
Today, though, let’s look at several ways that you could express the opinion that the market might go down a bit.
Multiple Ways to Play a Potential Market Drop
For this exercise we’ll concentrate on the S&P 500 index, noting that there are similar trading instruments for other market indexes.
Let’s look at a laundry list of ways to trade a market drop:
- The time honored way would be to sell short the index. One could do this by selling the futures contract (S&P e-mini symbol:ES) or selling short the Exchange Traded Fund (symbol:SPY).
- Tax-advantaged accounts (e.g., IRAs, SSRPs and the like) will not allow the use of margin that is required to sell short. For those accounts and really for any trader, there are inverse Exchange Traded Funds (ETFs) that rise in price by an equal percentage to the underlying index’s drop. For the S&P 500, one such ETF that trades over a million shares per day is the Proshares Short S&P 500 (symbol:SH).
- You can also add leverage to your inverse ETF by buying the UltraShort ETF that rises twice as fast, in general, as the market falls. The symbol of the most popular 2x inverse ETF is SDS. Over the past year, this ETF has had an average volume between 25 and 58 million shares per day! With the market at more extreme overbought levels today, SDS is trading at its lowest volumes of the year, but still averaging around 28 million shares a day!
- For even more leverage on a stock play, there are 3x leveraged ETFs such as SPXU, which is trading over 4.5 million shares per day.
- Of course, for really high leverage, one could buy options (puts) on stock for a higher reward-to-risk profile (for example, puts on the SPY). With this play, one would need to manage time decay, volatility changes and the other challenges involved with buying options premium.
Before we move on, let me remind everyone that leverage is very much a double-edged sword. While leverage offers the allure of higher returns, it also demands an increased need to manage a much higher level of risk.
Now, the number of ways to trade a correction is almost as limitless as your imagination; let’s look at one final way to play it. A professional money manager might incorporate leverage and risk controls with the use of an options spread. In this case, with the SPY currently trading at just over 129, you could buy an April 129 (at the money) put for about $4.00 and sell an April 125 (out of the money) put for $2.60 or a net cost of $1.40 per options contract pair.
Your downside risk would be strictly limited to $1.40 per position and your maximum upside is $4.00 per position. Of course by using a stop loss that kicks in before the spread price drops to 0, which is how most would play it, this spread presents a very good reward-to-risk profile.
For all of these trades, the protective stop loss could be placed just above the recent highs. Depending on how aggressive you’d like to be and your time frame expectations, one might place the stop 0.25 times to 1.5 times the Average True Range above the recent highs (or below the lows for the inverse ETFs).
A reasonable first profit target for a correction is the 124 – 125 area on the SPY.
I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…
Great Trading,
D. R.
Market Extremes: Common Themes and Characteristics January 21, 2011
Posted by smarttradepro in Current Issues.Tags: higher probability play is to follow the pattern., price slope lines are very good indicators, what the market is likely to do, When markets hit extremes
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“Markets can remain irrational a lot longer than you and I can remain solvent.”
“I should have drunk more champagne.”
– Both Attributed to John Maynard Keynes
The basketball had just been passed to me on the left wing. The game was tied late in the fourth quarter. It was my senior year at Radford High School and we were playing our arch rival, Blacksburg High School, the team that had ruined our perfect season at the junior varsity level just two short seasons ago.
Guarding me was an all-state football player, which meant that he was a superb athlete with great instincts in any sport. At this particular moment, we were running a set play. My role, once the ball got to me, was to make a decision: shoot if I am open (I was not) or pass to a player cutting toward me from the other side of the lane.
This was our standard set and the guy guarding me had already seen us run this play a half dozen times. In fact, he had almost intercepted my pass the last time we ran it; he was beginning to recognize the pattern of the play.
What happened next was the stuff of legend, a story I will tell my grandkids some day (or at least one I will share with the readers of Van’s newsletter…). I broke the pattern. I faked the pass that I had already made many times that night. Then, with a quick crossover dribble to my left, I zipped past a clearly superior athlete for an easy lay-up.
Pattern recognition had given my opponent an edge earlier in the game. Breaking the pattern turned the table back in my favor for this one play.
The markets play out this same “game” over and over again. The market follows a set pattern with great regularity, one that can be exploited if recognized early enough. And just when market participants get most comfortable, the pattern is broken. Let’s look at how to take advantage of both situations.
A Key Characteristic of Blow-Off Tops
When markets hit extremes, they usually do so for simple reasons. Buyers become overly enthusiastic and price an asset above a sustainable level. There are stages along the way in this process that go something like this:
- Recognition of initial price strength brings in aggressive institutional players.
- More conservative institutions then decide that they can’t miss the move and join in.
- Then retail players jump in “en masse” along with the last of institutions who are forced to have the “hot” asset in their portfolio.
- Finally, the end stage of the buying frenzy is powered by both greed and fear—players adding to profitable positions and the last new comers afraid of missing out on the move.
This pattern of staged entry for groups of buyers gives us reproducible signs of a blow-off top. My favorite indicator of this process is the accelerating rate of rise that we see in this chart that published in this newsletter just days before the 2008 peak in crude oil.
The blue lines under the price bars show a “progressively steeper ascent.” (My technical analysis friends will note that these blue lines are not “true” trend lines since only one of the four offers three points of resistance along its slope.) These lines show the acceleration of the price rise and can be an indicator of buyers coming into the market in clumps.
Two months ago, cotton hit all-time highs and was truly a runaway train! I don’t think I’ve ever been able to draw in five lines of steeper ascent. Price dropped more than 25% in the two weeks that followed and has since climbed to even higher highs.
And now for the kicker: the current equity market is looking like those other blow-off markets. Here’s a couple of charts showing the S&P 500. First, a longer view back to the March 2009 lows.
This gives us a perspective for the longer term trend and we’ve started to accelerate off of the lows set at the end of last August. Let’s take a closer look at this more recent time frame.
The markets really can’t sustain this type of upward movement for long. BUT, we must remember the quote attributed to Keynes—the market can remain “irrational” for a long time. And this is especially true when the massive governmental intervention is still working through the system.
The bottom line comes from our basketball analogy above. Patterns like the acceleration of price slope lines are very good indicators as to what the market is likely to do, and following them can help us locate pullbacks. As I learned in the basketball game, it’s the occasional break of the pattern that can lead to big payoffs.
So how can we play both sides of the trade? Here’s a useful general procedure:
- The higher probability play is to follow the pattern. In this case, play a short after a breakdown below the first or second slope acceleration line from above (depending on how aggressive you’d like to be).
- Then this becomes an “if not A, then B” trade. If it goes your way, fine. If not, you would reverse your position and go long on the breakout to new highs.
This type of strategy can help you play these market reversal points and take advantage of the predominate move (reversion to the mean) while giving you a chance to catch the directional move if the trend continues.
I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…
Great Trading,
D. R.
Precious Metals at a Decision Point January 14, 2011
Posted by smarttradepro in Current Issues.comments closed
There are many compelling reasons why gold, silver and other precious metals have had such an amazing run up in the last two years. Such severe action has brought us to a juncture point—perhaps even a watershed event.
The most compelling reason for the increase in the price of precious metals is very simple (my 3rd grade economics students learn this every spring before the annual economics competition in the state of Delaware): supply and demand.
In the case of precious metals (and all commodities denominated in dollars), the driver is the supply side. It’s no secret that the US has been printing new dollars at an unprecedented pace. So when the supply of dollars goes up by a huge amount while gold or silver only increases by a little, in the long run, the price of gold, silver and other commodities have to rise. And that’s what we’ve seen: gold has almost doubled since the beginning of 2009 and silver prices have more than tripled!
Let’s look at some gripping graphics that show how far precious metals prices have moved.
Gold to Silver Ratio: Always Informative
The ratio of gold to silver prices is almost always interesting. In short, the pair behaves similarly to large cap stocks versus small cap stocks with gold being the less volatile flight-to-quality instrument and silver playing the part of the bigger risk/bigger reward instrument). So when things are going well in the world of precious metals, silver usually outperforms its more valuable sibling. Let’s look at a chart that shows both metals’ prices and then compares the two in a single ratio.
This chart shows gold futures prices on the top, silver futures in the middle and the ratio of the two on the bottom between 2003 and today. One can think of the bottom in real terms as well as it tells us how many ounces of silver an ounce of gold will buy. Right now, you can get 46.62 ounces of silver with one ounce of gold—a figure that is in the extreme low end of the range. To bring that point home further, let’s put the relationship cycle in to perspective.
On this ratio chart from 1990 to today, you see that in the last decade, gold had been more valued relative to silver at equity market bottoms or fear points (purple ovals on top) while silver was in higher demand at equity market tops (red ovals on bottom). In general, just within the precious metal world, investors buy gold in times of uncertainty or fear and they prefer to buy silver when precious metal prices are moving higher.
Of course buyers prefer one metal over the other up to the point of exhaustion of the move. Having recently gone parabolic, the price of silver is giving us some signs of exhaustion.
Silver recently broke the phenomenally steep trendline that began at the end of August, but just barely so. The push up could easily continue from here, especially since the current sideways correction has relieved the overbought condition in this market. However, this parabolic ascent, along with the extreme compression in the gold to silver ratio points to a more sustained correction in the precious metals over the next few weeks or months. As always, macroeconomic policy changes in the US, Europe or Asia could delay or accelerate such a pullback.
For some really long term historical perspective (i.e., centuries), here’s a chart from the Austin Gold Information web site (Note: I haven’t vetted this precious metal sales company’s research, but saw this chart referenced on several other sites). Look at the volatility that has come into the precious metals market in the box, which is in just the last 150 years. For whatever reasons we might ascribe—and there are several obvious ones—the volatility with which we live now is unprecedented in terms of the truly long term prices of these two metals.
I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…
Great Trading,
D. R.
