Monthly Archives: July 2014

The RSI 3 Strikes and You’re Out Play

Please note the use of the word “Play” in the title.  Note also that it does NOT say “System” or “Method”, nor does it include anywhere the words “you”, “can’t” or “lose.”  So what is the distinction in all of this?

The use of the word “Play” is meant to denote that this should not be considered an “investment strategy”, nor even as a “trading method”.  In all candor it should basically be considered as a potential trigger or alert for traders who are willing to speculate in the market.  A few relevant notes:

1. Contrary to what many will tell you, there is nothing wrong with “speculating” in the financial markets.  There is a lot of money that can be made by doing so.

2. The key is in limiting the amount – and/or percentage – of capital allocated to each such trade.

3. Call and put options offer a great way to engage in this type of trading, because by their nature they allow you to “play” while using only limited sums of money.

Think about it this way.  Let’s say you “get a hankerin” to take a flyer on say a rally in the bond market.  Sure you could go out and buy t-bond futures contracts.  As I write they are presently trading north of 138.  At $1,000 a point, that means that the contract value is roughly $138,000.  You only need to put up margin money of about $3,000 in order to enter the trade.  Of course, if t-bonds decline from 138 to 135 then you have lost $3,000.  Good times, good times.

As an alternative you might have bought a call option on the ETF ticker TLT, which tracks the long-term bond.  As I write TLT is trading at $115.51, so to buy 100 shares would cost $11,551.  However, a trader looking to “play” could buy say a September 115 call option for all of $182.  If TLT rallied to say $118 by September expiration the 115 call would be worth $300, which would represent roughly a 65% gain.  And just as importantly, on the flip side, if TLT falls apart the most the option trader could lose would be $182.  Which reminds me of:

Jay’s Trading Maxim #312: If losing $182 on a trade is too much for you to bear – or will cause you great angst or to lose sleep or to beat yourself up – the “trading thing” might not be for you.

The RSI Three Strikes and You’re Out Play

So we will use the 3-day RSI indicator as a trigger to alert of a potential top.  Note the use of the phrase “potential top.”  Note also that nowhere do the words, “pinpoint”, “market” or “timing” appear.  So here is how it works:

1. (Day x) Price and 3-day RSI make a new high for a given move.

2. (Day y) After at least one intervening down day, price makes a higher close than on Day x BUT 3-day RSI stands below its level on Day x.

3. (Day z) After at least one intervening down day, price makes a higher close than on Day y, BUT 3-day RSI stands below its level on Day y.

4. After Day z the entry trigger occurs the next time price drops below the 3 day low.

To put it another way, after Day x price makes to higher closing peaks (with at least one down day between these peaks), while RSI on Day y is below RSI on Day x and RSI on Day z is below RSI on Day y.  OK, that’s as clear as mud.  So let’s go the “a picture is worth 1,000 words” route.

In Figure 1 you can see two examples of this “play” using ticker IWM, the ETF that tracks the Russell 2000 small cap index.  iwm rsi3Figure 1 – The RSI 3 Strikes and You’re Out Play using IWM (Source: AIQ TradingExpert)

In both cases the same scenario plays out.  Price makes two subsequent higher highs while RSI registers two subsequent lower highs.  The signal to buy put options comes when price takes out the three day low.

In the second example a trader could have bought a September 116 IWM put for $2.96 (or $296).  Eight trading days later that put was trading at $5.43 for a profit of $83%. iwm outFigure 2 – IWM put option using the RSI 3 Strikes and You’re Out play on IWM (Courtesy: www.OptionsAnalysis.com)

Summary

No one should get the idea that this simple “play” is the “be all, end all” of trading.  I specifically have not included any ideas on when to exit this type of trade so that no one gets the idea of trying to use this as a mechanical trading system.  Some traders may use a profit target, some may use an indicator, some may adjust the trade or take partial profits if a certain level of profit is reached, etc.

Like virtually any other trading idea, sometimes things will work out as hoped and sometimes they won’t.  The bigger lesson is that it is OK to speculate in the markets provided you do not expose yourself to large risks.  Which seems like good time to invoke:

Jay’s Trading Maxim #1: Your most important job as a trader is to make sure you are able to come back and be a trader again tomorrow.

Jay Kaeppel

Check the Dow on August 1st

Wow, that sounds pretty ominous and self important doesn’t it? (Hey, I gotta get people to click on the headline somehow!)

I will keep this short.  As I have been saying for some time, in my own mind I am scared to death that the market is getting far too overbought, the investing public is getting far too complacent, and the supposed “professionals” are getting far too bullish.  And for my own reasons I keep expecting something bad to happen between now and the end of September (followed by something good).

But despite all of this, I still haven’t sold a thing, for the simple reason that I am primarily just a dutiful trend-follower and the stock market just keeps moving relentlessly higher.  So who am I to say that the party is over?

But I am keeping a close eye on the weekly MACD for the Dow Jones Industrials Average.  Rather than going into a detailed explanation regarding “why” I will simply encourage you to review the material in this article – A Warning Sign to Watch.  (Hey, I did say I was going to keep it short, remember?).

In any event if and when the Weekly MACD for the Dow drops to negative territory, a more defensive stance may be in order.

djia macd

 

Figure 1 – Keeping an eye on Dow Weekly MACD (Courtesy: AIQ TradingExpert)

Jay Kaeppel

A Simple, Aggressive Approach to Large-Cap versus Small-Cap

Certain “arguments” just seem to last.  Since I started in this business (As best as I can recall, stock prices were reported on an abacus at the time) there has always been someone willing to pursue the “large cap versus small cap” and/or “growth stocks versus value stocks” argument.  Early in my career “everyone knew” that “in the long run” (usually defined – incorrectly – as the most recent 2-5 years) small cap stocks “outperform” large cap stocks.

Is this actually true?  The answer is “Yes, but only sometimes.”  The same answer holds true or growth versus value.  In short, no matter what you hear (at least in my humble opinion) there is no compelling evidence that large-cap stocks inherently perform better or worse than small-cap stocks nor that growth stocks perform better or worse than value stocks.  That’s the bad news.

The good news is that the interplay between large-cap and small-cap (and growth versus value) fluctuates – or more accurately, trends – over time.  In other words, it is not uncommon for large-cap stocks to outperform for awhile and then for small-cap stocks to outperform for a good long while.  If one can identify a trend then an opportunity exists.

One Simple, Albeit Aggressive Way to Play

The method I am about to describe is really pretty simple, however, it does involve risk as the method uses a leveraged mutual fund.  As a preface, the “safe” news is that this method is in the market only about 44% of the time (and is safely tucked away in cash the other 56% of the time). The “dangerous” news is that when it is in the market it is in a leveraged mutual fund that tracks large-cap stocks.  So, bottom line: it is not necessarily for the faint of heart.  More to the point though, it may be ultimately be useful to traders who are willing to invest a certain percentage of their capital in more “volatile” investments in hopes of an above average longer-term return.

So here are the steps:

A = Closing price for ticker RUI (Russell large-cap)

B = Closing price for ticker RUT (Russell small-cap)

C = 252-day % Rate of change for ticker RUI ((A / A 252 trading days ago)-1)*100

D = 252-day % Rate of change for ticker RUT ((B / B 252 trading days ago)-1)*100

E = (C – D)

If E > 0 this indicates that large-cap stocks have outperformed over the previous 252 days, and vice versa.

Trading Rules

If E > 0 today then buy ticker ULPIX (Profunds UltraBull) tomorrow and hold until E < 0.

If E < 0 today then sell ticker ULPIX and hold cash until E > 0

OK, not exactly “sophisticated”, still as a proud graduate of “The School of Whatever Works” (all hail good old “SWW”), I am far less interested in “process” as I am “results”. Which leads us directly to:

The Results

The test I ran started on 10/15/2001 when ticker ULPIX first began to trade.  The equity curves for the method described above versus buying and holding ticker RUI appear in Figure 1. jotm2014-0724-01Figure 1 – Growth of $1,000 using Jay’s ULPIX Method (blue line) versus buying and holding ticker RUI (red line); 10/15/01 through 7/23/14.

In a nutshell, $1,000 invested using the system grew to $4,257 versus $1,932 using a buy-and-hold approach.  The year-by-year results appear in Figure 2.

Year

System

RUI

2002

1.0

(22.9)

2003

26.6

27.5

2004

2.0

9.5

2005

(9.3)

4.4

2006

23.7

13.3

2007

8.0

3.9

2008

10.3

(39.0)

2009

49.7

25.5

2010

8.9

13.9

2011

6.8

(0.5)

2012

15.1

13.8

2013

8.0

30.6

2014

12.5

7.4

Average

13.0

4.5

Std Dev

15.8

19.8

A/SD

0.821

0.226

Figure 2 – Annual Results; Jay’s ULPIX System versus Buy-and-Hold

As you can see in Figure 2, since 2002 the system has averaged 13% annually versus just +4.5% for buy and hold.  It should also be noted that the standard deviation of annual returns was lower for the system.

On the downside investors should be sure to note that despite the fact that the “system” showed a gain for 2008, it nevertheless experienced a -42% drawdown during 2008. So just, repeating now, this method cannot be characterized as “low risk” in any way shape or form.

It is also worth noting that the annual system results versus buy and hold is all over the place.  So anyone looking for an endless string of “out performance” year after year, will definitely need to look elsewhere.  The proper perspective is this: when the system is in the market it occasionally makes a lot of money.  When it is out of the market it doesn’t make much at all – even if the stock market overall is rising.

For the record the system has been in ULPIX since the close on 5/7/14 and shows no immediate signs of getting out.  As of 7/23/14, RUI is up 17.8% and RUT is up 10.1% over the latest 252 days.  So “Value E” from above is +7.7%.  The system will continue to hold ULPIX (for better or worse) until Value E once again falls into negative territory.

Summary

As always, I am not recommending that anyone rush out today and jump into large-cap stocks just because the method I have described is presently bullish.  Nor am I even suggesting that anyone should adopt this system.  Before anyone engages in any type of trading that involves the use of a leveraged mutual fund, there are a few introspective questions to be asked and answered regarding one’s own tolerance for risk, what type of asset allocation is reasonable, and whether The School of Whatever Works offer classes online? (OK, just kidding about the last one).

The real point of this piece is twofold:

1) To dismiss the notion that large cap stocks are inherently a better investment than small-cap stock, or vice versa and;

2) To illustrate that with a little bit of analysis and effort it may be possible to come up with simple methods that take advantage of trends in the marketplace.

Now if you’ll excuse me, I have to get back to class.

Jay Kaeppel

 

Everything You Need To Know About the Stock Market in 2 Charts

I have been a little “quiet” lately.  Kind of unusual for me, granted.  But what can I say really that’s new?  The stock market’s moving higher – blah, blah, blah.  The bond market keeps trying to creep higher – sure, interest rates are basically 0%, so why not?  Gold stocks keep trying to grind their way higher after putting in an apparent base.  But who the heck ever knows about something as flighty as gold stocks?

So like I said, not much new to report. 

So for the record – one more time – let me repeat where I am at:

-As a trend-follower there isn’t much choice but to say that the trend of the stock market is still “up”.  So as a result, I have continued to grit my teeth and “ride”.  And let’s give trend-following its due – it’s been a good ride. 

-As a market “veteran” I have to say that this entire multi-year rally has just never felt “right”.  In my “early years” in the market (also known as the “Hair Era” of my life) when the stock market would start to rally in the face of bad economic times I would think, “Ha, stupid market, that can’t be right.”  Eventually I came to learn that the stock market knows way more than I do.  And so for many years I forced myself to accept that if the stock market is moving higher in a meaningful way, then a pickup in the economy is 6 to 12 months off.  As difficult as that was at times to accept, it sure worked. 

Today, things seem “different”.  By my calculation the stock market has now been advancing for roughly 5 years and 4 months.  And the economy?  Well, depending on your political leanings it is somewhere between “awful” and “doing just fine.”  But in no way has the “old calculus” of “high market, booming economy 6-12 months later” applied.

Again depending on your politics leanings the reason for this lies somewhere between “it is entirely Barack Obama’s fault” to “it is entirely George Bush’s fault.” (I warned you there was nothing new to report).

From my perspective, I think that the charts below – the second one of which I first saw presented by Tom McClellan, Editor of “The McClellan Oscillator” (which he presciently labeled at the time, “The only chart that matters right now”) – explains just about everything we need to know about the stock market actions vis a vis any economic numbers.

So take a look at the two charts below and see if anything at all jumps out at you.

spx mnthlyFigure 1 – S&P 500 Monthly (Source: AIQ TradingExpert)

qe

Figure – Fed Pumping (Quantitiatve Easing “to Infinity and Beyond”) propelling the stock market

I am not a fan of using the word “manipulation” when it comes to the stock market.  But I am a strong believer in the phrase “money moves the market.”  The unprecedented printing of – I don’t know, is it billions of trillions of dollars – has clearly (at least in my mind) overwhelmed any “economic realities” and allowed the stock market to march endlessly – if not necessarily happily – to higher ground.

Thus my rhetorical questions for the day are:

“What would the stock market have looked like the past 5 years without this orgy of money?”

“What happens to the stock market when the Fed cannot or will not print money in this fashion?”

Because this is all unprecedented in my lifetime (as far as I can tell) I don’t have any pat answers to these questions.  But I some pretty strong hunches.

My bottom line: Err on the side of caution at this time (http://tinyurl.com/p6zrqby).

Jay Kaeppel

 

Crash Insurance

Well it finally happened.  The stock market actually got “spooked” for a couple of days.  It’s been awhile.  And that kind of has me “spooked.”  Before I go any further I should state the following:

1) I am expecting some “trouble” between now and the end of September

2) However, as a dutiful trend follower I have yet to really act on those fears.

So when I write an article titled “Crash Insurance”, I am not necessarily suggesting that everyone rush out and buy some.  I am more or less just “planning ahead.”

I found the following link quite interesting (The 23 Charts Prove That Stocks Are Heading For A Devastating Crash) and suggest you give it a thorough read.  Although I don’t necessarily endorse the headline I do think something very unpleasant is quite possible, and the information contained flashes some clear warning signs.

If nothing else see the following:

Chart #4) QE to Infinity and Beyond qe

Figure 1 – QE to Infinity and Beyond (Chart Source: Forbes.com article “The 23 Charts Prove That Stocks Are Heading For A Devastating Crash” by Jesse Colombo)

This chart explains as plain as day why we have been in an endless bull market for years now (i.e., money moves the market, and when the Fed provides an endless supply, well, you get the drift).  When this chart turns down, be prepared to – all kidding aside – RUN LIKE HELL!

Chart #5) NYSE Margin Debt margin debtFigure 2 – NYSE Margin Debt (Chart Source: Forbes.com article “The 23 Charts Prove That Stocks Are Heading For A Devastating Crash” by Jesse Colombo; Chart generated by Doug Short at DShort.com)

In the 1975 classic “Market Logic”, Norman Fosback first noted that rising margin debt is bullish for the stock market (once again, money moves the market).  He also noted that when margin borrowing gets overdone and then turns down, it’s not such a happy thing for the stock market.  As you can see in the chart, the previous two spikes occurred during the run up to the 2000-2002 and 2008 bear markets.  The current level has recently declined from a new all-time high.  If this downtrend continues it will constitute an important warning sign for investors.

How to Buy “Crash Insurance”

In college I took a class on Insurance (Wow, was I a fun guy or what?  I digress).  What the teacher taught us was to “spend a little to cover alot.” In other words, spend a small sum of money to cover worst case calamity scenarios (granted this is different then what insurance has evolved into today whereby everyone wants everything to be covered and then wonders why the premium is so high…..but again, I digress).

SPY Put Option

One of the simplest way to “insure” against a market crash is to buy a put option on ticker SPY, the ETF that tracks the S&P 500 Index.  As I am looking for a bullish phase to begin on October 1st I need to go out to October options.  In Figure 3 we see the “Probability Calculator” screen from www.OptionsAnalysis.com.  Highlighted are the potential -1, -2 and -3 standard deviation price levels.

spy prob

Figure 3 – Probability Calculations for 9/30/14 (Source: www.OptionsAnalysis.com)

The October SPY put option with the lowest “Percent to Double” is the October 198 put option.  As I write the option trades at $5.79 (or $579).  The risk curve for buying one October 198 put appears in Figure 4.  The lower boundary is set to the -3 standard deviation price shown in Figure 3 (166.10).spy put Figure 4 – Risk Curves for October SPY 198 put (Source: www.OptionsAnalysis.com)

As you can see in Figure 4, if by chance SPY does fall apart between now and October expiration, this option will gain a lot in value.  Of course if the market moves sideways to higher instead this option could expire worthless and the buyer would lose a maximum of $579.

Summary

I am not suggesting that now is the exact right moment to consider buying a put option on SPY.   As always I am not “recommending” the trade above.  The example I’ve shown is simply intended to give you the idea of how to use put options as a potential alternative to “selling everything”.  You should also be aware that via the use of options there are other more “sophisticated” strategies available.  Buying a put option to hedge is sort of a “hammer to nail” approach – crude but effective.

In any event, as indicated in the Forbes article in the link above, there are some “clouds beginning to build”.  Which leads directly to:

Jay’s Trading Maxim #102: It is better to know where to find shelter now  in case an actual storm breaks out than to have to “run for cover” somewhere down the road.

Jay Kaeppel

The Tempting Siren Song of Gold Stocks

If you are a “chart” guy or gal you may have taken notice of some interesting developments in gold stocks over recent months.  A strong argument can be made that a “bottom formation” has – well – formed and that price is now in the early stages of a new bullish trend.  Is this an accurate picture?  Let’s take a closer look.

The Chart Picture

The great thing about looking at price charts is that you can see pretty much whatever you want to see in them – er, I mean, there are many different possible interpretations.  In Figure 1 we see a weekly bar chart for ticker GDX – the Market Vectors ETF that tracks a gold stock index.gdx weekly Figure 1 – GDX Weekly Bar Chart with Support, Resistance and Triangle pattern highlighted (Courtesy: ProfitSource by HUBB)

As you can see there is a (OK, somewhat subjectively drawn) support and resistance range between roughly $20 and $32.  There is also a triangle pattern forming as price consolidates into a more narrow range.  Now for the record I got burned by incorrectly guessing the direction of a triangle breakout in ticker GLD recently (link), but I am not much of a “Once bitten, twice shy” kinda guy.  For me it’s more like, “Fool me once, shame on you, fool me twice – damn! I fell for it again.” Cest la vie.

Still, the point is that price action seems to be “coiling” within a larger trading range, so now is the time to start planning what action to take, if any.

In Figure 2 we see a weekly bar chart for ticker GDX with the Weekly Elliott Wave count plotted, as calculated objectively by ProfitSource from HUBB. gdx ew Figure 2 – GDX weekly with Elliott Wave (Courtesy: ProfitSource by HUBB)

As I always I should point out that I do not “blindly trust” Elliott Wave counts.  Sometimes they play out with “uncanny accuracy”, other times, well, not so much.  Still, for what it is worth, the current count is projecting a potential move from $26 to roughly $38 to $42, potentially by the end of this year. 

So this raises two questions:

Question 1: Do you think there is a chance that gold stock prices will advance in a meaningful way between now and the end of the year?

Question 2: Are you willing to risk a couple hundred bucks while waiting to find out?

Option Plays in GDX

As is always the case when dealing with options, the possibilities are limitless.  One possibility is to use the “stock replacement strategy”.  With this approach a trader buys a deep-in-the-money call option that will emulate a stock position at a fraction of the cost.  For example:

*To buy 100 shares of GDX would cost $2,645

*To buy one December 20 GDX call would cost just $675

The Dec 20 call has a “delta” of 93 which means it will act like a position holding 93 shares of GDX, but will cost only 27% as much as buying the shares.  The particulars for the Dc 20 call trade appear in Figure 3. gdx dec 20Figure 3 – Long 1 Dec 20 GDX call @ 6.75 (Source: www.OptionsAnalysis.com)

An alternative would be:

*Buy 6 Dec GDX 28 calls @ 1.43

*Sell 6 Dec GDX 33 calls @ 0.32

This trade would cost $666 and the particulars appear in Figure 4.gdx dec 28 33 bcs Figure 4 – Long 6 Dec GDX 28-33 bull call spreads (Source: www.OptionsAnalysis.com)

This trade has a delta of 170, which means it will act like a position holding 170 shares of GDX, i.e., up to a point it can make money much more quickly than the Dec 20 call position for the same investment $.

Comparing the Two Trades

Figure 5 displays the two trades (one Dec 20 GDX call for $675 versus six Dec 28-33 GDX bull call spreads).gdx overlayFigure 5 – GDX Dec 20 call versus GDX Dec 28-33 Bull call spread  (Source: www.OptionsAnalysis.com)

The Dec 20 call enjoys unlimited profit potential and eventually could make more than the Dec 28-33 bull call spread.  However, based on the earlier Elliott Wave analysis, we are looking at (OK, hoping for)  a move to the $38-$42 range (which would be a huge move).

So if GDX does in fact rise between now and December the Dec 28-33 bull call spread enjoys better profit potential. 

Summary

As always, there are many ways to play just about anything in the financial markets, particularly when options are involved.  Also as always, I am not “recommending” either of these trades.  The purpose here is simply to highlight:

*One way to trade options instead of stock shares and get essentially the same position at a fraction of the cost (i.e., the Dec 20 call).

*One way to create greater upside potential for the same cost (i.e., the Dec 28-33 bull call spread)

Finally – and also as always – there are tradeoffs and caveats to keep in mind.  In this case, two that come to mind are:

1) GDX MUST move higher for either of these trades to make any money.

2) YOU MUST be patient and wait for the move to play out (assuming it does) over a multiple month period of time.

Which leads us to close with:

Jay’s Trading Maxim #57: When patience is required in trading – the urge to become impatient suddenly tends to surge.  So prepare yourself mentally to fight the “urge to surge.”  

Jay Kaeppel