If You Just Have to Pick a Bottom in Crude Oil…

OK, let’s be candid about this title.  The reality is that no one ever “has to pick a bottom.”  In fact, we are advised time and again to avoid this very activity as it is considered to be “dangerous”, “foolhardy” and/or “unlikely to succeed”, depending on the person dispensing the wisdom.

Still, if you are reading this article then chances are you are doing so because at some point in your (checkered?) trading past you have either been tempted to “pick a bottom (and/or top)” or you have actually tried to do so.  So you know deep down that it is probably not a very good idea.  Still, it sure is tempting isn’t it?  I mean let’s be honest here.  Who doesn’t want to be able to say they “picked the bottom” in, well, something, whatever. And you sure can make a lot of money if you get in at exactly the right moment.

So let’s dispense with niceties and conventional wisdom and acknowledge the fact that we are in fact imperfect beings, complete with foibles, faults, bad habits and extremely subject to human nature (and isn’t that a pain in the rear).  So if you consider yourself to be a “trader” it may be hard to look at the recent freefall in oil and perhaps gold prices and not say “Man, this thing is due to bounce.  I wonder if there is a way to play this?”  So let’s take a look at one way to play a potential bounce in crude oil.

A Few Important Caveats

1) I haven’t the slightest idea if crude oil will bounce soon or not.  In fact, if my gut told me that it was then my first reaction would likely be to ignore it (but enough about my own personal psychoses’).

2) Regardless of whatever the rest of this article says the cold hard reality is that this exact moment in time is probably not the moment that crude oil will bottom out.  In fact, it could continue to fall precipitously for some time to come.

3) Yes, trying to pick a bottom in anything is in fact analogous to attempting to catch a falling knife. It’s a really cool trick if it works, but it can get a little messy otherwise.

So I am NOT “predicting” that crude is about to bounce and I am NOT recommending that you take the trade I will discuss in a moment.

So what is the point?  The point is this: There is a right way and a wrong way to do everything, no matter how wise or foolish the current “thing” in question may be.  If you are going to pick a bottom then you want to do two things:

1) Understand going in that you are playing a long shot so prepare yourself mentally in advance to fail (in fact you might even want to go ahead and prepare yourself to kick yourself and say “What the heck was I thinking about?”).

2) Do everything possible to minimize your risk based on current circumstances.

One Way to Play a Bounce in Crude

OK, all caveats out of the way, let’s now go ahead and “take the plunge.”  A few key factors:

1) My own personal opinion is that any trade that attempts to pick a top or bottom should involve the use of options.  Why?  Simple – limited risk.  To better appreciate this, imagine the poor schlub who bought a January 2015 crude oil futures contract on 10/3 when the 2-day RSI (which I like by the way) dropped below 5, thus strongly suggesting that crude oil was “oversold”.  As you can see in Figure 1, since that time, Jan2015 CL has fallen from 87.87 to 55.91. At $1,000 a point, that works out to a loss of -$32,900 per contract.  Ouch.  And thanks for playing our game.cl f1

Figure 1 – “Oversold” Crude Oil not such a Bargain (Courtesy: AIQ TradingExpert)

2) The current “waterfall” decline in crude is not without precedent.  In Figure 2 – which displays a continuation chart of crude oil futures – you can see several occasions when the bottom dropped out of crude oil, so to speak.  In the past these types of declines have typically lasted 3 to 8 months.  The current decline is in its 6 month. Likewise, as of 12/16, the monthly 2-month RSI was at its lowest reading in 30+ years of trading.  The point here is not to argue that a reversal is imminent, only that it isn’t entirely crazy to think that a bounce is possible.cl f2Figure 2 – Crude Oil “waterfall declines” past and present (Courtesy: AIQ TradingExpert)

The least expensive way to play a potential bounce in crude oil is via options on ticker USO, the ETF that tracks (more or less) the price of crude oil.  In Figure 3 you see the USO bar chart with the 90+ day implied option volatility plotted.

cl f3Figure 3 – Implied Volatility for USO options has “spiked” (Courtesy: www.OptionsAnalysis.com)

IV has spiked to its highest level in years.  This has important implications for option traders. High implied volatility simply tells us that there is a lot of time premium built into the price of USO options.  As a result, traditional bullish strategies such as buying calls or bull call spreads may be poor choices for someone looking to play a bounce.  This is because implied volatility typically (albeit not always) declines when a security bounces higher off of a panic selling bottom.  Selling a bull put spread might make sense as an alternative.  However, I personally don’t advocate that strategy in the face of an ongoing waterfall decline.  A bull put spread is best used when there is some sort of support level that a trader can use as an “uncle” point.

So what to do?

What to Do

Well as I stated earlier, for the vast majority of traders the best course is to “do nothing” and NOT attempt to pick a bottom in crude.  However, we are talking about what actions a trader might consider if he or she has decided to “take a flyer”.  So here is one possibility – a “Reverse Call Calendar Spread.”

As long as we are breaking all the rules I think it is OK to point out that a reverse calendar spread is a strategy that most traders will never use, and in most cases should never use.  But every tool has its use.  What we are looking for in this case is:

1) Price movement between now and the first week of February, and;

2) A decline in implied volatility

So one way to play is:

*Buy 1 Feb 2015 21 Call @ 1.46

*Sell 1 Mar 2015 21 Call @ 1.77

The prospects for this trade appear in Figures 4 and 5.cl f4Figure 4 – Reverse call calendar spread for USO (Courtesy: www.OptionsAnalysis.com)cl f5Figure 5 – Reverse call calendar spread for USO (Courtesy: www.OptionsAnalysis.com)

A few key things to note for starters:

1) Assuming this trade is held until February expiration and implied volatility remains unchanged this trade (based on a 1-lot) has $31 of profit potential and $80 of risk.

2) “Vega” represents the amount that the trade will gain or lose if implied volatility rises by 1 percentage point.  This trade has a Vega of $-0.67.  This means that if volatility keeps rising lose potential may also increase.  However, if IV falls the profit potential for this trade will increase.  If IV falls 10 percentage points the profit on this trade will increase (roughly) $6.70.

3) Implied volatility for the options in this trade are extremely high (45% or more) on a historical basis.

4) From a risk management perspective the most important thing to note is that this trade should NOT be held until February option expiration.  By planning to be out no later than two weeks prior to expiration (i.e., by Feb. 6) we completely eliminate that potential of experiencing the maximum potential loss, and in fact reduce the worst case scenario significantly.

Let’s make the following assumptions to highlight exactly what this trade is designed to achieve.  The information in Figures 6 and 7 assume:

1) That the trade will be held no later than Feb. 6, and;

2) That implied volatility falls 40% from current level (i.e., current IV x 0.6)

In Figures 6 and 7 you clearly see the potentially positive implications for a meaningful decline in implied volatility.cl f6Figure 6 – USO reverse calendar if IV declines back under 30% (Courtesy: www.OptionsAnalysis.com)cl f8Figure 7 – USO reverse calendar if IV declines back under 30% (Courtesy: www.OptionsAnalysis.com)

In this scenario, the maximum risk declines to roughly -$5 on 1-lot and the break-even range is greatly compressed thus significantly raising the probability of a profitable trade.

Summary

So all in all, it is typically a bad idea to try to pick a top or bottom in the financial markets.  But all of us are human, and human nature can occasionally lead a trader to “feel the urge.”  If the urge is too great and you feel you must act, then remember to do everything in your power to limit your risk.

If your bottom picking trade works out, great (but don’t let it go to your head).  And if it does not, then at least you didn’t “bet the ranch.”

Jay Kaeppel

Seasonal E-mini Strategy – 42 Wins and 0 Losses?

Don’t you just hate titles like this one?  I mean if you are into the stock market you almost can’t help but to click on it – even if for no other reason than to seek the answer to that age old question, “What’s the catch?”

Now in this case the title is accurate, at least in the hypothetical sense.  But as you probably know, for any book, article or publication the name is everything.  For example, if the title of this article were “Would You Be Willing to Risk $3,000 on a Trade for the Chance of Making as Little as $25 on Said Trade?” (which would also be hypothetically accurate), you would be a lot less likely to click on the link, right?  I mean let’s be honest here.

So, yes, technically you can’t judge a book (article or publication) by its cover.  But in reality, we all do it all the time.  So just remember that  the people designing the covers have a vested interest in getting you to open the cover, so be forewarned.

Hence the title of this article.  But since you’ve already “cracked open the cover”, why not read on a little further?  (Insidious, no?)

A Seasonal Oversold “Idea”

Note the use of the word “Idea” in the section title.  And also please remember that the word “idea” is quite different from the words “sure” and/or “thing” and way different from the phrase “you can’t lose.”  So again, be forewarned.  In the interest of full disclosure I am not attempting to urge you to use the “idea” spelled out below – only to be “aware” of it and to consider whether or not it might “fit your style.”

So what’s this all about?  Simple.  Awhile back I wrote a piece titled “Happy Days are Here, Um, Next Monday?” that in a nutshell highlighted the fact that the stock market tends to perform well between the close of trading on the Friday before Thanksgiving and the close of the third trading day of the following January.  The “idea” in this article builds from that trend.

Entry Rules

Here are the “rules” (to paraphrase the immortal words of Bill Murray, they are really “guidelines” more than “rules”, but here goes):

*If today is between (and including) the Friday before Thanksgiving and the third trading day of the New Year, AND;

*The 2-day RSI is below 30, a “buy alert” is signaled.

*After a “buy alert” occurs, a “buy signal” occurs when the E-mini S&P 500 exceeds a previous day’s high price (however, a “buy signal” cannot occur after the third trading day of January).

Exit Rules (OK, again – Guidelines):

*Sell if the E-mini S&P declines 60 (i.e., $3,000 per contract) points from the buy trigger price (i.e., the previous day’s high + 0.25 points), OR

*On the first profitable close.

Results

Starting in November 2004 there have been 42 trades.  During this time there have been no post buy declines of 60 points (although a few have come close), hence the reason no losing trades.

Figure 1 displays the most recent signal using the December 2014 E-mini S&P 500 contract.

es-ss 1 Figure 1 – Seasonal Oversold Trade for 2014-2015 (so far); Source: AIQ TradingExpert

Figure 2 displays the trades from the 2013-2014 periods. es-ss2Figure 2 – Seasonal Oversold Trade for 2013-2014 (Source: AIQ TradingExpert)

Figure 3 displays the trades from the 2012-2013 periods.

es-ss3

Figure 3 – Seasonal Oversold Trade for 2012-2013 (Source: AIQ TradingExpert)

Figure 4 displays the trades signaled each year during the bullish seasonal period (assuming a 1-lot per trade).

Trade # Entry Date Exit Date Buy Price Sell Price Points +(-) per Trade $ +(-) per Trade MaxDD Pts. per Trade MaxDD $ per Trade
1 11/23/04 11/24/04 1179.25 1182.00 2.75 $137.50 (7.75) ($388)
2 12/01/04 12/01/04 1179.75 1189.75 10.00 $500.00 (4.75) ($238)
3 12/09/04 12/09/04 1187.00 1190.75 3.75 $187.50 (11.25) ($563)
4 12/20/04 12/21/14 1203.75 1208.00 4.25 $212.50 (8.50) ($425)
5 12/01/05 12/01/05 1263.25 1264.50 1.25 $62.50 (11.50) ($575)
6 12/12/05 12/13/05 1272.75 1277.00 4.25 $212.50 (9.00) ($450)
7 12/21/05 12/22/05 1272.25 1275.50 3.25 $162.50 (5.50) ($275)
8 01/03/06 01/03/06 1259.25 1274.75 15.50 $775.00 (7.75) ($388)
9 11/29/06 11/29/06 1392.75 1402.25 9.50 $475.00 (0.50) ($25)
10 12/11/06 12/14/07 1428.00 1438.25 10.25 $512.50 (11.00) ($550)
11 12/27/06 12/27/06 1431.25 1437.00 5.75 $287.50 (0.25) ($13)
12 11/23/07 11/28/07 1440.00 1442.00 2.00 $100.00 (33.25) ($1,663)
13 11/26/07 11/28/07 1444.25 1470.50 26.25 $1,312.50 (37.50) ($1,875)
14 11/28/07 11/28/07 1441.25 1470.50 29.25 $1,462.50 (0.25) ($13)
15 12/05/07 12/05/07 1478.00 1487.00 9.00 $450.00 (1.25) ($63)
16 12/19/07 12/20/07 1471.75 1474.75 3.00 $150.00 (16.00) ($800)
17 11/24/08 11/24/08 814.50 848.00 33.50 $1,675.00 (7.25) ($363)
18 12/03/08 12/03/08 851.00 868.50 17.50 $875.00 (24.75) ($1,238)
19 12/16/08 12/16/08 885.50 912.75 27.25 $1,362.50 (9.75) ($488)
20 12/26/08 12/29/08 870.00 870.50 0.50 $25.00 (16.75) ($838)
21 11/23/09 11/23/09 1102.50 1103.75 1.25 $62.50 (1.25) ($63)
22 12/01/09 12/01/09 1104.75 1108.50 3.75 $187.50 (2.50) ($125)
23 12/04/09 12/22/09 1112.25 1113.50 1.25 $62.50 (3.75) ($188)
24 12/10/09 12/11/09 1097.75 1103.25 5.50 $275.00 (5.25) ($263)
25 12/21/09 12/22/09 1107.75 1108.25 0.50 $25.00 (11.25) ($563)
26 01/04/10 01/04/10 1124.25 1128.75 4.50 $225.00 (4.75) ($238)
27 11/24/10 12/01/10 1187.75 1196.50 8.75 $437.50 (11.50) ($575)
28 12/01/10 12/01/10 1197.50 1204.50 7.00 $350.00 (0.50) ($25)
29 12/16/10 12/21/10 1244.50 1250.75 6.25 $312.50 (12.00) ($600)
30 01/03/11 01/03/11 1258.50 1265.25 6.75 $337.50 (3.25) ($163)
31 11/28/11 11/28/11 1174.50 1191.00 16.50 $825.00 (5.25) ($263)
32 12/09/11 12/09/11 1250.50 1253.00 2.50 $125.00 (17.75) ($888)
33 12/15/11 12/20/11 1218.75 1236.00 17.25 $862.50 (23.25) ($1,163)
34 12/20/11 12/20/11 1218.75 1236.00 17.25 $862.50 (20.00) ($1,000)
35 12/30/11 01/03/12 1258.75 1272.00 13.25 $662.50 (8.00) ($400)
36 12/05/12 12/06/12 1412.00 1413.00 1.00 $50.00 (15.25) ($763)
37 12/17/12 12/17/12 1419.50 1427.00 7.50 $375.00 (10.25) ($513)
38 12/26/12 01/02/13 1424.75 1457.00 32.25 $1,612.50 (42.50) ($2,125)
39 12/31/12 12/31/12 1417.00 1420.00 3.00 $150.00 (33.50) ($1,675)
40 12/06/13 12/06/13 1794.50 1803.75 9.25 $462.50 (8.75) ($438)
41 12/16/13 12/16/13 1783.25 1786.00 2.75 $137.50 (17.75) ($888)
42 12/02/14 12/02/14 2061.25 2066.00 4.75 $237.50 (10.50) ($525)
Points $ Points $
Average 9.32 $466 (11.74) ($587)
Median 6.00 $300 (9.38) ($469)
Max 33.50 $1,675 (0.25) ($13)
Min 0.50 $25 (42.50) ($2,125)

Figure 4 – Hypothetical Trade-by-Trade Results

A few things to note:

*42 winners, 0 losers

*Maximum drawdown per 1-lot = -$2,125

*Average winner in points (dollars) = +9.32 (+$466)

*Median winner in points (dollars) = +6.00 ($300)

*Average Maximum drawdown per trade in points (dollars) = -11.74 (-$587)

*Median Maximum drawdown per trade in points (dollars) = -9.38 (-$469)

Summary

So on the face of it, anything that is capable of generating 42 consecutive winning trades would seem to have some merit to it.  On the other hand, with any trading method it is critically important to look “under the hood” and make some realistic assessments regarding the actual usefulness of said method.

The system rules include a 60 point stop-loss for the E-mini S&P 500 futures contract.  At $50 a point, this equates to a potential loss of $3,000 per contract per trade.  The average dollar profit was only $466 and the median dollar profit per trade was $300.

The key elements of risk in this method then are:

1) One losing trade of $3,000 could require a number of trades to come back from.

2) Using a tight stop-loss will result in a number of losing trades that would ultimately have ended up winners.

So the question for a trader to ask is – can we judge this book by its cover?

Jay Kaeppel

Three Sector Funds for December

December has historically been a bullish month for the stock market. In fact, over the past 24 years, buying and holding an S&P 500 Index fund during the month of December would have netted a gain 20 times, or 83.3% of the time, with an average gain of almost +2% (+1.93% actually).  A lot of investors might be tempted to say “That’s good enough for me”, and who could blame them?

But there might be a way to do even better.

Certain sectors show historical tendencies to perform well during certain times of the year.  So let’s look at a simple 3 fund portfolio that has performed quite a bit better than the S&P 500 over the past 24 years.

The “December Three”

The three sectors are Biotech, Software and Home Construction.  Figure 1 displays some potential trading vehicles.

Sector Fidelity ETF
Biotech FBIOX IBB
Software FSCSX VGT
Home Construction FSHOX XHB

Figure 1 – Fidelity and ETFs

Results

For testing purposes we will use the Fidelity funds listed in Figure 1 as they have historical data going back much further than the ETFs listed.

Figure 2 displays the annual result of a portfolio split evenly between the three funds versus the S&P 500 Index.

Fid 3

Figure 2 – Annual Results: 3 Fidelity Sector Funds vs. SPX

Figure 3 displays the growth of $1,000 invested only during the month of December in the “Fidelity 3” versus the S&P 500 Index. Fid 3 chartFigure 3 – Growth of $1,000 invested in Fidelity 3 versus SPX (1990-2013)

Figure 4 displays the relevant comparative figures.  fid 3 results

Figure 4 – Comparative Results

A few things to note:

*The Fidelity 3 has gained an average of +4.21% versus +1.93% for SPX.

*The Fidelity 3 median gain was +2.52% versus +1.25% for SPX.

*The Fidelity 3 has showed a higher standard deviation, but also a *higher Average/Standard Deviation.

*The worst December for the Fidelity 3 was -4.99% versus -6.03% for SPX.

*Interestingly, the Fidelity 3 has been up 19 times and down 5, versus up 20 and down 4 for SPX.  However – and most importantly – the Fidelity 3 has outperformed SPX in 18 of the past 24 years.

Summary

So are biotech, software and home construction guaranteed to show a gain and outperform the S&P 500 this December.  Not at all.

But for an investor looking to “beat the market”, it certainly is “food for thought.”

Jay Kaeppel

Happy Days Are Here, Um, Next Monday?

It is not a little known fact that historically the action of the stock market has been relatively favorable both around holidays and towards the end of the year.  But some question remains as to just how favorable things have been during these periods and how often.  So let’s address it.

The Year-End (or “Santa Claus”) Rally

Different analysts will look at historical data and draw different conclusions.  This is actually a good thing, otherwise everyone would be trying to buy or sell at the same time.

But in the opinion one analyst (“Hi, my name is Jay”) the “year-end rally” period (or as I like to call it the “Santa Claus Rally”):

*Starts on the Monday before Thanksgiving

*Ends at the close of the third trading day of the following January

Have I mentioned lately that this stuff doesn’t need to be rocket science?

So how has this period performed?  We will start our test at the close of trading on Saturday (yes, Saturday) November 19, 1949 and examine what would have happened to a hypothetical $1,000 investment in the Dow Jones Industrials Average that was in the market only during the bullish year-end period described above (in other words, the trader would buy the Dow Industrials Average at the close on the last trading day prior to the Monday before Thanksgiving and would hold through the close of the third trading day of the following January.  The rest of the time the “system” is out of the market.  For our purposes, no interest is earned so as to reflect only the gains made during the bullish year-end period).

The results appear in chart form in Figure 1.santa rallyFigure 1 – Growth of $1,000 invested in the Dow Industrial Average only during the bullish year-end period described in text

Figure 2 displays the annual year-by-year results in table form.

Exit Date

% +(-)

1/5/50

3.6

1/4/51

4.0

1/4/52

3.9

1/6/53

4.6

1/6/54

2.9

1/5/55

5.1

1/5/56

0.2

1/4/57

3.7

1/6/58

(0.0)

1/6/59

5.7

1/6/60

5.8

1/5/61

3.2

1/4/62

(1.0)

1/4/63

5.0

1/6/64

8.2

1/6/65

(1.2)

1/5/66

3.0

1/5/67

(0.5)

1/4/68

4.3

1/6/69

(3.1)

1/6/70

(2.4)

1/6/71

10.0

1/5/72

11.6

1/4/73

3.4

1/4/74

(1.2)

1/6/75

3.6

1/6/76

6.0

1/5/77

3.1

1/5/78

(3.7)

1/4/79

3.6

1/4/80

1.6

1/6/81

1.5

1/6/82

0.9

1/5/83

2.3

1/5/84

2.5

1/4/85

(0.3)

1/6/86

5.7

1/6/87

4.3

1/6/88

6.5

1/5/89

6.2

1/4/90

5.4

1/4/91

0.6

1/6/92

13.9

1/6/93

2.4

1/5/94

2.8

1/5/95

0.9

1/4/96

3.7

1/6/97

1.5

1/6/98

0.3

1/6/99

4.2

1/5/00

1.1

1/4/01

2.7

1/4/02

4.0

1/6/03

(0.4)

1/6/04

9.5

1/5/05

1.3

1/5/06

1.1

1/5/07

0.4

1/4/08

(2.9)

1/6/09

12.0

1/6/10

2.5

1/5/11

4.6

1/5/12

5.3

1/4/13

6.7

1/6/14

1.6

Figure 2 – Year-by-Year “Santa Claus Rally” % +(-)

A few performance notes:

# times UP = 54 (83% of the time)

# times DOWN = 11 (17% of the time)

Average% +(-) = +3.19%

Median % +(-) = +3.08%

Largest % Gain = +13.87% (1991-92)

Largest % Loss = (-3.69%) (1977-78)

It is also worth noting that the year-end rally period has witnessed a gain for the Dow in 27 of the last 29 years and 33 of the last 36 years.

Summary

So do the results displayed in Figures 1 and 2 guarantee that the stock market is destined to rally in the near future?  Ah there’s the rub.  For the answer is “not necessarily”.  Still, investing is in many ways a game of odds and probabilities.  While one always needs to be prepared to act defensively if things start to go south, history suggests that traders and investors might do well to give the bullish case the benefit of the doubt between Thanksgiving Week and early January 2015.

Or to put it more succinctly:

Jay’s Trading Maxim #215: Santa Claus is real (approximately 83% of the time).

Jay Kaeppel

Darknet Channels Strikes Again

In the May 2014 issue of “Technical Analysis of Stock, Commodities & Forex” magazine, I co-authored an article with John Broussard, a former colleague of mine.  John is the purveyor of www.OptionsAnalysis.com and developer of the Darknet Channels trading method.

Now when I say that we “co-authored” the article, in this case that breaks down sort of like this:

John: Researched, tested, designed, developed, programmed, refined, launched and maintains the Darknet Channels system.

Jay: Ran spell check and grammar check.

In addition, Jay also wonders why – even though John thoroughly explained the calculations and methodology behind Darknet Channels – he still doesn’t full understand exactly how they work.  Alas, some questions are best left unanswered.  But hey, at least the spelling and grammar look good.

Darknet Channels: The Broad Stroke

In a nutshell, Darknet Channels involves calculations that draw three sets of price channels which we will refer to as long, intermediate and short-term channels.  When all three sets of channels are pointing lower and long short-term and intermediate-term channels are contained within the longer-term channels, then the stage is set for a buy signal (a reversal in price is required first in order to avoid attempting to “catch a failing safe”).

Once a buy signal occurs then the system looks for the opposite configuration – i.e., all three channels are pointing higher and the short and intermediate-term channels are contained within the longer-term channels.  Then the stage is set for a sell signal.  Once again, reversal in price of some degree is required to trigger the actual signal. 

Figure 1 displays some recent example signals for ticker SPY.spy darknetFigure 1 – Darknet Signals for SPY

Trading with Darknet Channels

www.OptionsAnalysis.com generates Darknet Signals for a large number of stocks.  Also, the software generates signals on Stocks, Call Options and Put Credit Spreads.  It likewise has its own built in methodology for selecting specific options to trade. 

Not being one to leave well enough alone (Sorry, its jut my nature), I have my own list of tickers that I follow and my own method for selecting call options to consider based on the trading signals that the software generates.

My “short list” of tickers includes:

AXP BA DIA EEM IBB IWM SPY SSO XHB XLB XLF XLI XLP XLV XLY XOP

Also the method I use for selecting options for consideration uses the following inputs in the % to Double routine built into www.OptionsAnalysis.com:darknet input 

Figure 2 – Jay’s Option Selection Inputs

The primary things to note among the inputs are:

*At least 45 days until expiration

*Volume and Open Interest of at least 1 (i.e., ignore call options that never trade)

*Use the “Natural” price (i.e., the ask price) for evaluation purposes (this give you an idea of what price you might get if you placed a market order)

I make no claim that these are the “best” selection criteria to use.  They are based on certain personal preferences (I would rather buy a slightly longer term option than to have to “roll out”, I don’t like to look at options that never trade and I like to consider my “worst case, what price do I buy at if I place a market order” scenario, rather than assuming that I can get filled at the midpoint of the bid/ask spread).  That being said, traders may often be better off buying with a limit order than a market order.  

In sum a trader can follow the trades suggested by the software, use the criteria I have listed above, or device some other variation – for example, some traders might consider deep-in-the-money call options as a “stock replacement” strategy.

Some Recent Results

The results displayed in Figure 3 are hypothetical and represent just one recent set of results from using Darknet Channels buy signals and the option selection criteria shown above.  It is assumed that $2,500 is dedicated to each trade.darknet hypothetical results Figure 3 – Hypothetical Results of Recent Darknet Channels signals

The results in Figure 3 do not include any deductions for slippage or commissions, so net returns would be less than they appear in this table.  Still, the gist is that investing up to $2,500 into each of these 8 positions – at a cost of around $20,000 – would have generated close to a doubling of capital before slippage and commissions.

Summary

No trader should look at any set of hypothetical results and come away with stars in their eyes.  The market had a great rally off of the October low so good gains were obviously there for the taking for call buyers.  But the real point of this piece is not so much to “sell” you on Darknet Channels as it is to make you “aware” that a mechanical and back tested model is available that can generate these types of returns under the right circumstances. 

For more information visit www.OptionsAnalysis.com.

Jay Kaeppel

Actually Doing Something with The 40-Week Cycle

Last time out I revisited the 40-Week Cycle in the stock market.  Or as I sometimes refer to it, the “Wow this sounded like a really stupid idea when I first read about it, I don’t remember where, 30 some odd years ago, but darned if it hasn’t held up reasonably well Cycle” (so you see why I typically just go with the shorter version).

In the last piece I spelled out the “numbers” and I pointed out the fact that the “bullish phase” is most certainly not always bullish and that the “bearish phase” sees the stock market advance more often than it sees it decline.  But over the long-term the difference in results has been rather stark (with “stark” being defined in this case as a gain of +3,538% during the bullish phases – assuming the 12.5% stop-loss was respected – versus a loss of -31% during the bearish phases. 

I also stated quite clearly that “No one should rely on the 40-week cycle as their sole method of market analysis.”  Which is all perfectly logical.  But it does raise a rather pesky question of “So what the heck do I actually do with this thing, anyway?”  The short answer is “combine it with something else.”  Let me give you an example.

A Model Incorporating the 40-Week Cycle

So let’s build a simple (with “simple” in this case being defined as “Jay thinks its simple”) model that incorporates the 40-Week Cycle as a factor.  In addition to that cycle we will also incorporate the “Best Six Months” pattern and the 50-day/200-day moving averages for the Dow Industrials.  So heretofore I will refer to this as the “296 Model” (40 + 6 + 50 + 200).

296 Model Tool #1 – The 40-Week Cycle:

As defined last week, every 280 calendar days (the latest period started at the close on 10/31/2014) the stock market enters a “bullish phase” that lasts for 140 calendar days or until the Dow drops 12.5% from its price at the start of the current bullish phase.  The rest of the time this Tool is in cash.

296 Model Tool #2 – The Best 6 Months:

This well known phenomenon from Yale Hirsch and Stock Trader’s Almanac fame turns bullish at the close on the last trading day of October and turns bearish at the close of the last trading day of the following April.

The 296 Model – Tool #3: The 50-day versus 200-day Moving Averages:

This tool turns bullish when the 50-day moving average for the Dow Industrials rises above the 200-day moving average.  It stays bullish until the 50-day moving average drops back below the 200-day moving average.  And so on and so forth.

296 Model Scoring:

When a “Tool” is “bullish” it adds 1 point to the model

When a “Tool” is “bearish” its adds 0 point to the model

So the score for any given day can range anywhere from 0 to +3.  Intuitively, we would expect better market results when the readings are higher than when they are lower.  And in this (rare, at least when it comes the stock market) case, intuition proves to be fairly spot on.

The 296 Model Results

We start our test on 12/31/1967.  We will refer to readings of 0 or +1 as “bearish” for reasons that become more apparent with a perusal of Figure 1.  Figure 1 displays the growth (or perhaps I should say “lack thereof”) of $1,000 invested in the Dow Jones Industrials Average only on those days when the 296 Model registers a reading of 0 or +1.  40-6-50-200 BearFigure 1 – Growth of $1,000 invested in the Dow Industrials only when The 296 Model is at 0 or +1 (12/31/67-present)

As with the 40-week cycle bearish phase chart last week, a close look at Figure 1 reveals that there are plenty of times when stock market advanced along the way.  So just because we refer to these readings as “bearish” no one should assume that the stock market is automatically guaranteed to decline.  Still, what is significant is that all told, since the end of 1967 this $1,000 would have declined in value to $349 (or -65.1%).  Which is not exactly the kind of long-term growth most investors are looking for. 

Figure 2 displays the growth of $1,000 invested in the Dow Jones Industrials Average only on those days when the model registers a reading of +2 or +3.  Also, 1% of interest per year is added when out of the stock market.

40-6-50-200 Bull Figure 2 – Growth of $1,000 invested in the Dow Industrials only when The 296 Model is at +2 or +3 (12/31/67-present)

A simple visual observation suggests that the results depicted in Figure 2 are “better” than those that appear in Figure 1.  In fact, $1,000 invested in the Dow only when the 296 Model stands at +2 or +3 (with 1% annual interest while in cash) grew to $67,012 (or +6,601%).

So a quick review:

*296 Model Bullish % +(-) = +6,601%

*296 Model Bearish % +(-) = (-65%)

These are the kinds of numbers that we “quantitative types” refer to as “statistically significant.”

Also, the maximum peak-to-valley drawdown for the 296 Model was -29% versus -54% for buy and hold. 

The 296 Model turned bullish at the close on 10/31/14 when both the 40-week cycle and the Best 6 Months turned bullish raising the model reading from +1 (the 50-200 moving average was already bullish) to +3.  The model will remain above +1 at least until 3/20/2015 (when the 40-week cycle returns to “bearish”).  As we will see in a moment, this may or may not prove significant.

A Closer Look at the Results

Now if I were smart I would write my typical snarky Summary and hit “Publish.”  But alas, well, never mind.  In any event, in this case I feel compelled to go the extra step and point out the critical difference between:

A) “Building a model” (which is the easy part) and;

B) “Actually trading using said model” (which is the hard part).

Which reminds me of:

Jay’s Trading Maxim #132: Between theory and reality there can be a chasm a mile wide.  So look for a sturdy bridge when attempting to cross from one to the other.

On the surface the numbers for the 296 Model look pretty darn good.  But the reality is that a lot of imperfections can get glossed over during the course of 37 years (come to think of it, a lot of hair can disappear also.  But I digress).  So before anyone gets the bright idea that they should adopt the 296 model right away, at least consider the following “bad news”:

1) In a nutshell, the Model’s average annual gain was +10.4%, versus +7.8% for Buy/Hold (this includes no dividends in the calculation, so the total return for both the Model and buy and hold would be several percentage points higher).  Not bad, but not exactly eye-popping either.

2) The Model did show a gain in 38 of 47 years versus 34 up years for buy and hold.  But the bad news is that the Model actually underperformed buy and hold 26 out of 47 years. 

This last piece of info is a little shocking and highlights the real fact behind how the Model outperforms buy and hold over time: It simply “doesn’t get clobbered” as often or to the same extent as buy and hold during bear markets.

So the good news is that when the market gets whacked, the 296 Model trader may well be sitting in cash and missing out on all of the “angst.”  On the other hand, during a rip roaring bull market the Model trader will also find him or herself occasionally sitting on the sidelines as prices soar.  This can be a very frustrating state of affairs.

In reality, a lot of traders and investors subconsciously adopt the “That Championship Season” mentality when it comes to trading.  In other words, if we didn’t beat the market this year then we didn’t “win the championship” regardless of the long-term affect.  For example, let’s say over a two year period that during Year One the Model made 14% and buy and hold made 20%. The next year the Model makes 1% while buy and hold loses 20%.

After two years the Model investor will see $1,000 grow to $1,151, whereas a buy and hold investor would have only $960.  Still, human nature being what it is, the average Model trader will look at the Model as being 50/50 against the market, i.e., one year it beat the market, the next year it did not.  All in all this highlights the never-ending need for discipline in following any trading method or model.

To put a fine point on all of this consider these two slightly incongruous facts:

1) Since the end of 1990, the 296 Model has underperformed buy and hold during 16 of those 24 calendar years (including 2014 to date).  Let’s face it, the average trader would likely find this a little hard to take.

2) On the other side of the coin, despite this fairly brutal year-by-year comparison, since the end of 1990, $1,000 invested in the Dow using the 296 Model grew to $10,023 versus $6,601 using a buy and hold approach. 

How is this possible?  As mentioned above, and as seen in Figure 3, the Model “doesn’t get clobbered” as often as buy and hold.40-6-50-200 Model 1990+ Figure 3 – Growth of $1,000 for 296 Model (red line) versus Buy and Hold (blue line) from 12/31/1989 to present

So despite the fact that the 296 Model did not have many “Championship Seasons”, it still managed to gain 1.6 times as much as buy and hold (+902% versus +560%).  Go figure. [I am getting a little tired so please insert your own “Tortoise vs. Hare” type analogy here].

Summary

When it comes to trading coming up with “interesting ideas” is relatively easy.  In fact, coming up with models that outperform a buy and hold approach is not as hard as many people assume. 

Unfortunately, actually using those “interesting ideas” and models to trade can sometimes prove a great deal more difficult.  By virtue of human nature we want to make money, we want to make money right freaking now, and we want to consistently make more money in the future.  And if we are underperforming the overall market for any length of time then “something is wrong” and we will more than likely feel compelled to “do something” – which more often than not will ultimately work against us, Murphy’s Law being what it is and all (Wow, is human nature a pain in the rear or what?).

The 296 Model I’ve detailed here is a perfectly good case in point.  Three useful tools – each with a good standalone track record – combined into one “weight of the evidence” model which generates results that are inarguably superior to buy and hold.  Sound great, right?

But unless you understand how it manages to achieve that outperformance (by missing some of the big “downs” – but alas, also some big “ups”) and unless you have the psychological wherewithal to withstand “underperforming the market” over the course of several years and still “stay the course”, achieving those really great long-term results may be problematic.

Which leads me to conclude with:

Jay’s Trading Maxim#2: There are two keys to trading success; the first is to develop a well-though out method that has a realistic probability of generating profits in real-time trading (i.e., you must have a plan). 

Jay’s Trading Maxim #3: The second key to trading success is that you must have the emotional and financial wherewithal to follow your plan.

(Ironic) Hint: While #2 can involve a lot of work and effort, for most people #3 is way harder than #2. 

Jay Kaeppel

The 40-Week Cycle Revisited

As I mentioned last time around, when it comes to analyzing the financial markets, I am a proud graduate of “The School of Whatever Works”.  In my youth I “wrote down” a lot of interesting analysis ideas (that’s how we did it back then, sadly).  Whenever I would hear or read of a new market analysis or market timing idea, rather than passing judgment one way or the other based solely on my own “youthful wisdom” (har, good one), I would agnostically write it down and “track it for awhile”.  OK, “quantitative” is  not a word that most “youths” get around to using until, well, whatever it is that comes after youth (which I believe most people refer to as “Mid-20’s and broke”, or alternatively, “Our parents have stopped feeding us, now what?”  But I digress).

At lunch time I would take a break from my job in “Personnel” (which coincidentally is where I came to realize that I “hate people” and that I was going to have to do something that involved numbers instead) and go to the local library and peruse the available market newsletters, advisory services, etc.  Anyway, I had quite the appetite for “market analysis” so I “wrote down” a lot of “stuff.” 

Long story short, if I had a $1 for every idea/method I wrote down that did not stand the test of time, well, let’s just say I wouldn’t need to worry about analyzing the financial markets anymore.  But I guess that shouldn’t really come as a surprise.  What surprises me more is some of the ideas that I would likely have considered “arcane” (had I actually used that word in my youth) that actually did end up standing the test of time (at least so far).  One of those is something I refer to as the “40-week cycle.“ 

Now I am certain that I personally did not “invent” the 40-week cycle.  I must have read about it somewhere (OK, original thinking isn’t my strong suit, is that a crime?),written it down and followed it.  But sadly, I don’t remember exactly when or where or from whom I first got the idea.  But whoever you are, if by some strange twist of fate you are reading this article, let me just say “Thanks.”

The 40-Week Cycle   

For the record there is the “Raw theory 40-week cycle” and the “Raw theory 40-week cycle with a stop-loss provision added because you know how that pesky stock market loves to crater even the best theories every once in a while” version (which I considered as the title for my next book but my editor emphatically said “No!” Guess the price of ink must be up these days).

The Rules are pretty simple:

*Starting at the close on 4/21/1967, the first 140 calendar days (20 weeks times 7 days) is considered the “Bullish Phase”

*The second 140 calendar days is considered the “Bearish Phase”

*During the Bullish Phase, if the Dow Jones Industrials Average losses 12.5% or more from its closing level at the end of the previous “Bearish Phase”, sell and remain in cash until the start of the next Bullish Phase.

Figure 1 displays this cycle going back a few years.40 week hubb Figure 1 – Dow Industrials with 40-Week Cycle dates (Courtesy: ProfitSource by HUBB)

There are three critical things to know about the raw 40-week cycle:

1) The stock market DOES NOT always go UP during each bullish phase.

2) The stock market DOES NOT always go DOWN during each bearish phase (in fact, for the record, the “Bearish Phase” has seen the Dow advance more often than it declined.  But when it does decline, it “really declines” – see Figure 3 below).

3) No one should rely on the 40-week cycle as their sole method of market analysis (even at the peak of “Youthful Wisdom”)

With those caveats in mind, let’s look at why it still may be useful to keep an eye on this cycle as a “weight of the evidence” tool.

The Results

For measuring results during the “bullish” phase:

Buy the Dow at the close on the last day of the previous Bearish cycle.

Sell if either:

a) The Dow declines 12.5% or more on a closing basis from the buy price, or;

b) 140 calendar days go by if a) is not triggered

For our purposes, we will assume that interest is earned at a rate of 1% per year while out of the stock market.  Starting on 4/21/67, $1,000 invested using the rules above would be worth $36,483 as of 10/31/14, as shown in Figure 2.40wk v bhFigure 2 – Growth of $1,000 using 40-Week Bullish Phase Rules (blue line) versus Buy and Hold (red line)

On the flip side, had an investor skipped all of the “bullish” days and invested only during the “bearish” days (including after the 12.5% stop was hit), he or she would have done, ahem, worse.  The growth of $1,000 invested only during the “non bullish” days appears in Figure 3.40wk bearFigure 3 – Growth of $1,000 invested only during “Non Bullish” 40-Week Bullish days

To be succinct:

*$1,000 invested only during the “Bullish” days grew to $36,483 (+3,548%)

*$1,000 invested only during the “Non Bullish” days shrank to $688 (-31%)

Summary

The latest bullish phase started at the close of trading on 10/31/2014 (and extends through 3/20/15).  This nicely coincides with the “Bullish Six Months” period originally espoused by Yale Hirsch which (according to my own rules) extends from the close of trading on October 31st each year through the third trading day of the following May.  So does this combination of bullish seasonal factors guarantee us that “Happy Day are Here Again?” 

Sadly, no.  Murphy and his d$%^ Law stand ever vigilant against complacent investors. But if history is a guide (and “sometimes” it is) we might continue to give the bullish case the benefit of the doubt.

Well, at least for another 139 days.

Jay Kaeppel

Is Gold “Waving” Goodbye?

Typically, I don’t like to rain on other people’s parades – you know, karma being what it is and all.  And when it comes to analyzing the financial markets and trading, I am a proud graduate of “The School of Whatever Works.”  So if someone tells me that the key to their success comes from analyzing the ratio between the VIX Index and the price of arugula, I say “more power to ‘em.”  (OK, this is a made up example.  Please DO NOT email me and ask me if I have back data for the price of arugula.  I do not.  At least not that I am aware of.  Maybe I do.  I should look. Wait, no!).

So anyway, what follows is not meant to denigrate anybody else’s analysis.  But one thing that has always bugged me is when people arbitrarily draw all kinds of things on a price bar chart and then say “Aha!” One notorious example is a guy I used to know who was a big believer in Gann and Fibonacci (not that there is anything wrong with that).  So if we were to talk (assuming we were still talking) about the gold market he might send me a chart that sort of resembles the one that appears in Figure 1.  This is a weekly bar chart for ticker GLD – an ETF that tracks the price of gold bullion – with a Gann fan and Fibonacci Retracement lines drawn. gld w gann and fibFigure 1 – Ticker GLD with a Gann Fan and Fibonacci Retracements (Courtesy: ProfitSource by HUBB)

As you can see in Figure 1 there is in fact a point where the 61.8% “Fib line” (as we “professional market analysts” like to refer to them) will intersect with the, well, one of the Gann Fan lines.  Is this actually significant in any way?  [Insert your answer here].  But I would likely respond to him by saying something constructive like, “Interesting analysis.  Hey what about the other 50 lines you’ve drawn on this chart?”  To which he would likely respond by saying something equally constructive like “$%^ you.” (You kind of get the idea why we don’t talk much anymore). 

For the record please note that at no time did I denigrate his analysis (well, maybe in a sneaky, snarky sort of way – sorry, it’s just my nature).  But if it works for him, that’s great.  But seriously, what about the other 50 lines?  And please remember that for the sake of clarity I did not include the 4 to 6 “key” moving averages that he would normally include on a typical bar chart.  Anyway, in the end it seems like an appropriate time to invoke:

Jay’s Trading Maxim #102: If you draw enough lines on a bar chart, price will eventually touch one.  This may or may not signify diddly squat.

or the addendum:

Jay’s Trading Maxim #102a: The market may not care that you’ve drawn a particular line on a particular chart.  Just saying.

So with this in mind, let’s turn to the price of gold and Elliott Wave Analysis.

Gold and the Elliott Wave

I always feel compelled to point out that I am not now, nor have I ever been a true “Elliotthead.”  But I know enough traders whom I respect who are serious users of Elliott Wave analysis that I do try to pay attention.  So let’s take a look at a recent example, in this case using the ticker GLD.

The biggest problem I always had with Elliott Wave is figure out when one wave is – um, waving goodbye and another wave is about to crest.  So I rely on ProfitSouce from HUBB to do the work for me.  In Figure 2 you see a bar chart for ticker GLD with ProfitSource’s version of the latest Elliott Wave count drawn.  As you can see in Figure 2, the indicated wave count just crossed down into a bearish Wave 5 (although most of the people I know who follow Elliott Wave refer to this as a “Wave 4 Sell”.  Go figure).gld ewFigure 2 – GLD and Elliott Wave w/Wave 4 Sell signal (Courtesy: ProfitSource by HUBB)

So let’s assume that a person wanted to play the short sort of gold based on this one signal (for now we will ignore the question of whether or not this is wise).  One avenue would be to sell short 100 shares of GLD at $119.34.  This transaction would involve putting up margin money of roughly $6,000 and assuming unlimited risk to the upside (Remember that if you sell short shares of GLD and gold decides for some reason to open $20 higher tomorrow your stop-loss to buy back your short GLD shares at $125 is not necessarily going to limit your risk).

My preferred play would be to use put options on ticker GLD.  Of course, with options there is always “more than one way to play.”  So let’s look at two.

Strategy #1: The “I Want to be Short Gold” Strategy (Buy a Deep-in-the-Money Put)

The objective with this strategy is to get as close to point-for-point movement with the underlying security (i.e., shares of GLD) as possible, at a fraction of the cost.  In this example, the trade in Figures 3 and 4 involves buying the December 127 put at $8.40. gld put1Figure 3 – Buying Deep-in-the-money GLD Put (Source: www.OptionsAnalysis.com)gld put2 Figure 4 – Buying Deep-in-the-money GLD Put (Source: www.OptionsAnalysis.com)

This trade costs $840 – which represents the maximum risk on the trade and has a delta of -79.77.  This means that this trade will act roughly the same as if you had sold short 80 shares of ticker GLD (which would entail putting up margin money of roughly $4,800 and the assumption of unlimited risk. 

If GLD falls to the upper price target range indicated in Figure 2 (112.20) this trade will generate a profit of roughly $700.  As this is written, GLD has fallen from    119.34 to 115.76 a share and the December 127 put is up from $8.40 to $11.40 (+36%).

Strategy #2: The “I’m Willing to Risk a Couple of Bucks in Case the Bottom Drops Out of Gold” Strategy (buy an OTM Put Butterfly)

This strategy is for people who are willing to speculate and risk a few dollars here in there in hopes of a big payoff.  Now that phraseology probably turns a few people off, but risking a few bucks in hopes of a big payoff is essentially the definition of intelligent speculation.  

So for this I turn to www.OptionsAnalysis.com which helpfully has an OTM Butterfly Finder routine built in.

This trade involves:

Buying 1 December 118 put

Selling 2 December 108 puts

Buying 1 December 98 put

The cost of this trade is only $170. gld put 3Figure 5 – Buying OTM Butterfly spread in GLD (Source: www.OptionsAnalysis.com)

gld xFigure 6 – Buying OTM Butterfly spread in GLD (Source: www.OptionsAnalysis.com)

As you can see, if GLD does fall into the price range projected by the Elliott Wave count shown in Figure 2, this trade can make anywhere from $250 to $700 or more based on $170 of risk.

As I write, GLD is trading at $115.76 and this open position shows a profit of $94 (+55%).

Summary

There sure are a lot of ways to analyze and play the financial markets.  As a proud graduate of “The School of Whatever Works” (our school motto is “Whatever!”) I am not here to tell you what tools you should use (nor how many lines you should draw on a bar chart) or what type of trading strategies you should use to act on any particular trading strategies.  My only purpose in this blog is to provide food for thought.

Whether or not a single particular Elliott Wave count constitutes a valid trading signal is up to each trader to decide.  But whatever the indicator, once a signal to play the short side is given, more choices arise.  In this example, three choices are to:

1) Sell short shares of GLD (putting up margin money and assuming significant risk),

2) Buy an in-the-money put option to track the price of GLD without as much cost and with limited risk

3) Risk less than $200 to gain exposure to the downside in GLD

Food for thought.  Feel free to “chew on that” for awhile.

Jay Kaeppel

It Doesn’t Have to be Rocket Science (Part 312)

Seems like I have used this title before.  That’s probably because I have.  It’s also because every once in awhile I lift my head up from “crunching numbers” – in pursuit of that “one great market timing method” – and remember that there really is no such thing and that having a general sense of the overall trend of the markets and adding a touch of common sense can get you pretty far as an investor and trader.

Of course, that’s been easier said than done of late.  At times its seems that common sense would dictate doning a Hazmat suit and curling up in the fetal position in a corner until – you know, whatever – passes.  With an election coming up we have been informed by both sides that if the other side wins then that will pretty much be the end of humanity as we know it.  Which leaves us exactly where?  But I need to watch my blood pressure so I will steer clear of politics.

My Writing (or Lack Thereof) of Late

I have been writing very little of late.  The good news for me is that JayOnTheMarkets.com is not a paid site and there are no deadlines and no one is waiting for me to tell them what to do next in the markets.  Which is probably a good thing since the truth is that I have never been more unsure of exactly what the h?$% is going on in the markets (or the world around us, come to think of it) than I have been of late.   Hence the lack of more frequent updates.  As the saying goes, “If you don’t have something intelligent to say, don’t…” – well come to think of it I have never really adhered to that rule in the past.  Never to late to start, I guess.  In any event, thank goodness I am a systematic trader.

In trying to make sense of things, on one hand a perusal of the evidence in recent months led me to think that a major top was forming.  On the other hand, the trend (except for a recent short-lived dip by some of the major averages below their 200-day moving averages) has remained “up” and we are now in what has historically been a very bullish seasonal period (also the standard most bullish 6 months of the year starts on November 1st).  

So the bottom line is that if you want to be bullish you can make a pretty good case.  On the other hand, if you want to be bearish you can also make a pretty good case. 

What’s a guy or gal to do? 

Well hopefully your answer is the same as mine: Continue to follow your objective, well thought out trading plan – one that incorporates some risk controls in case things don’t go the way you planned. 

Sounds so simply when its put that way, doesn’t it?  Towards that end, let me offer a simple “Non Rocket Science” method for identifying the long-term trend of the stock market.

Jay’s Non-Rocket Science Stock Market Trend Identification Method (JTIM)

Notice that this ridiculously long title (hence JTIM for short) includes the phrase “Trend Identification” and not the phrase “Market Timing”.  If I were truly interested in full disclosure the title would actually be something like “Jay’s Non-Rocket Science Let’s Not Ride the Bear Market All the Way to the Bottom for Crying Out Loud” Method.  But that one was really long winded. 

The purpose of this method is simply this, nothing more, nothing less: to avoid riding an extended bear market all the way to the bottom all the while hoping that one day it will bounce back.  When this method gives a sell signal it simply means that it “may be” time to play defense.  That might mean selling a few stock market related holdings, that might mean selling everything related to the stock market, or it might mean hedging and existing portfolio.

It also means that there is a chance that you may take defensive action and later end up wishing that you had not.  Sorry folks, that just kind of the nature of trend following.  But one thing I have learned since, well, the time I had a lot of hair until now, is that selling now and buying back in at a slightly higher price is typically preferable to riding a 20%, 30% or 40% or more drawdown.

Now some people may respectfully disagree with that opinion.  But these types of drawdowns can scar an investor’s psyche – and adversely affect their judgement in the future – for  a long time – even after their portfolio eventually bounces back.  In addition, riding a massive drawdown like DiCaprio and Winslet riding the final plunge of the Titanic opens an investor to one of the most devastating mistakes of all – i.e., selling at or near the bottom (Though fortunately not to hypothermia like DiCaprio – and just for the record, seriously, couldn’t Winslet have just schooched over a little bit and made enough room for both on that door or whatever it was she was floating on? But I digress).

This reminds me to remind you of:

Jay’s Trading Maxim #78: Drawdowns make people act stupid (the more the drawdown, the more the stupid).

So here are the (granted, imperfect) JTIM rules:

*If the S&P 500 Index closes for two consecutive months below its 21-month moving average AND also closes below its 10-month moving average, the trend is deemed “Bearish”.

*While the trend is deemed “Bearish”, if the SPX 500 Index closes one month above its 10-month moving average then the trend is deemed “Bullish.”

That’s it.

JTIM Results

The results must be measured based on what the method is trying to achieve – i.e., avoiding massive, long term drawdowns – so as to avoid “acting stupid” (and to avoid ending up like DiCaprio, but I repeat myself).  Over the course of time the results look pretty good.  Of course, it also depends to some extent on how you define “good”, because from time to time – and over certain extended periods of time between the beginning and end – the results don’t look so good.  Allow me to explain.

In general terms, it goes like this:

Good: This method avoided most of the 1973-1974 bear market.

Not So Good: Between 1977 and 1991 there were 5 “sell” signals.  In all 5 cases an investor who “sold everything” based on these signals would have bought back in at a higher price.  An investor would have missed drawdowns of -9.6% in 1977-78 and -12.7% in 1981-82.  But all other sell signals during the great bull market of the 80’s and 90’s witnessed drawdowns of no more than -4.0%. 

Good: The last three sell signals (2000, 2002, and 2008) were followed by drawdowns of -28%, -29% and -50%, respectively.   

Figure 1 displays the results in tabular form:spx timing Figure 1 – Jay’s Trend Identification Method Signals

The key thing to note is that over the past 40+ years this method outperformed buy-and-hold (by almost 2-to-1 if interest earned while out of the market is added in; See Figure 6).

Figures 2 through 5 display the signals on SPX monthly bar charts. SPX Timing 1Figure 2 – SPX with JTIM Signals 1970-1984 (Courtesy: AIQ TradingExpert)

SPX 2 Figure 3 – SPX with JTIM Signals 1984-1994 (Courtesy: AIQ TradingExpert)

SPX 3 Figure 4 – SPX with JTIM Signals 1994-2004 (Courtesy: AIQ TradingExpert)SPX 4 Figure 5 – SPX with JTIM Signals 2004-2014 (Courtesy: AIQ TradingExpert)

Figure 6 displays the growth of $1,000 using JTIM (adding 1% of interest per year while out of the market) versus buy-and-hold since 1970.Figure 6 Figure 6 – Growth of $1,000 using JTIM (blue line) versus buy-and-hold (red line) since 1970

And just to complete the picture Figure 7 displays the growth of $1,000 invested in SPX only when the system is bearish.  Figure 7Figure 7 – Growth of $1,000 when JTIM is bearish (1970-present)

For the record, had an investor bought an held the S&P 500 only during those period when JITM was bearish since 1970, an intitial $1,000 investment would now be worth only $540 (i.e., a loss of -46%).  Or as we “professional market analysts” refer to it – Not So Good.

Summary

So is this the “be all, end all” of market timing?  Clearly not.  During most of the 80’s and 90’s, getting out of the market for any length of time typically cost you money.  Still, since nothing of the “be all, end all” variety actually exists  some investors may find it useful to note the status of this simple model, at the very least as an alert that:

a) a lot of bad news can typically be ignored if the model says the trend is “up”, and,

b) some defensive action may be wise if the  model says the trend is “down.”

Alright, excuse me, I have to get back into my Hazmat suit.

Jay Kaeppel

Light at the End of the Tunnel? (or do I hear a Train Whistle?)

Wow, does Murphy hate my guts, or what?

So I write an article all about how the stock market gets all bullish during the middle 18 months of the decade (September 30th – Mark Your Calendar) – i.e., starting at the close on September 30th of the mid-term election year – and what does Murphy go and do?  He (She? Hmmm, that might explain a few things) invokes his (her?) dreaded Law and the market gets hammered right out of the box in early October.

Fortunately for me I have made enough mistakes in the market over the years that I don’t even bother to feel stupid anymore when things go exactly the opposite of what I might have anticipated.  This leads me to invoke a maxim I adopted (after a long, painful process) a long time ago:

Jay’s Trading Maxim #412: Murphy hates you.  Plan accordingly.

To put it into other terms, it essential for any trader or investor to give some thought as to  what might go wrong before taking any particular action and to come up with an answer to the following question:

“What is my worst case scenario and what specific action will I take to mitigate the damage should this scenario unfold?”

Sounds like such an obvious question to ask and answer doesn’t it?  But here is another question that will likely make a lot of readers squirm:

“Do you have an answer to the question above?  Every time you make a trade?”

OK granted that’s two questions, but you get my drift.

Where to From Here?

So here is the part of the article where most “highly trained professional market analysts” tell you why the market is almost certain to rise (or fall) from here. Unfortunately, the bad news for me is that I am not very good at predicting the future (plus let’s face it, I can’t risk pissing Murphy off again).  So while it “feels” like the market could melt down at any moment, I have little choice but to simply follow my plan and give the bullish case the benefit of the doubt.  So two things to note:

#1. October through December in Mid-Term Election Years

In Figure 1 you can see the growth of $1,000 invested in the Dow Jones Industrials Average only during the months of October, November and December during mid-term election years, starting in 1934 (i.e., 1934, 1938, 1942, etc.)oct-dec midterm 1 Figure 1 – Growth of $1,000 invested in DJIA Oct-Nov-Dec of Mid-Term Election Year (1934-present)

Figure 2 shows the year-by-year results

oct-dec midterm 2

Figure 2 – DJIA performance Oct through Dec of Mid-Term Election Years

As you can see, this period has showed a gain 90% of the time.  Granted a few were pretty miniscule, still the median gain was in excess of 8% and the worst previous performance was -7%.

#2. Short-Term Oversold

Well I could hardly refer to myself as a highly trained professional market analyst if I didn’t have my own proprietary  overbought/oversold indicator, so, voila, surprise, surprise, my own proprietary overbought/oversold indicator (cleverly named JKOBOS) appears in Figure 3.jkobos Figure 3 – Jay’s Overbought/Oversold Indicator is flashing an oversold (i.e., theoretically bullish) signal at the moment (Chart courtesy of AIQ TradingExpert)

A close look at the chart in Figure 3 reveals that JKOBOS readings below 25 tend to highlight decent buying opportunities.  With the indicator presently standing at 21.8, this qualifies as at least a “bullish alert”.

Summary

So is the combination of a bullish seasonal trend (i.e., October through December of Mid-Term election years) and an oversold market (based on a reading from my own overbought/oversold indicator) telling us that another rally is in the near future? 

The honest answer is “not necessarily”.  The optimistic answer however, is that despite the fear and loathing that seems to permeate the market these day (or maybe partly because of it), there is a chance that the market could surprise to the upside.  As a dutiful trend follower I personally have little choice but to continue to give the bullish case the benefit of the doubt.

Just don’t anyone tell Murphy I said that………sssshhhh!

Jay Kaeppel