Thursday, October 23, 2008

Daily Volatility Bands

I have learned to use volatility bands derived at 5% intervals away from the 150-day moving average. Take a look at how the Dow has been trading the last 12 days (Black Box) and you can see why. Look at how the trading has been bound between the -20% Band (Red Line) and the -30% band (Green Line), with the -25% Band (Blue Line) as the pivot.

I don’t invent any of this stuff. I just study a lot and learn what big money uses in determining how and when they deploy money or sell holdings.
Here is the NASDAQ 100 Index. See how it has tagged the -35% Band three times in the past 9 trading days (Black Arrows). This pattern is referred to as the “Charlie’s Angels” or a “Triple Bottom” (geek humor at it’s finest!). There is no such thing as a “Quadruple Bottom”, so the 1,175 level had better hold, or the next leg down will have begun.

The blue arrows are supposed to show today’s low of 1,177.17 versus the -35% Band at 1,178.51, but I cropped the picture poorly.

The S&P 500 Index ($SPX) and the Retail Sector (RTH) have similar charts.

All I can tell you is that these recent lows had better hold! We’ll see. If the lows fail, then there will be ample opportunity to make big piles of money in a short period of time. If the lows hold, then there may be a chance to make some decent coin of a reversion back to the 50-day average (currently 10,589 for the Dow Jones and 1,154 for the S&P 500).

A break above the trend line for RTH may set up a decent rally.

I’m going to do a lot of homework this weekend and see where good entry points are and if big money shows up to buy this market in the next few days, I will have stop buy orders in place to participate with them.

If big money starts to sell the markets hard again and takes out the recent lows, I will have stop buy orders in on the short ETFs and participate with them in the ensuing bloodbath.

I don’t care which way the markets go. I just want to be invested in the direction of the primary trend. I have ample resources to be invested Long or Short in very efficient vehicles. So I don’t care if the markets are rallying or crashing, because I can make money either way. This skill has allowed me to miss most of the pain of the last 14 months.

At some point, the markets will bottom and a new Bull Market will commence. I’m not smart enough to guess at what price the markets will bottom. I assume that the Dow and the S&P will undercut the lows of the 2000-2003 Bear Market, just to scare the heck out of people. But I will let the markets tell me when it is again time to get fully invested.

Remember, bottoming will be a process of 6 to 12 months. Leadership will show up and I have the skill to identify it when it does. Right now, there are 2 potential leading stocks in the Universe of 6,000 that trade decent volume. It will take months for new leadership to start showing up. I’ll keep you posted.

Thursday Trading

I sold my short positions in the first few minutes today and then looked to go long at some point later in the day.

200% Short Financials (SKF) bought 10/22 at $142 and sold on a stop limit of $153.5
200% Short Materials (SMN) bought 10/22 $85.5 and sold at market for about $92.5

I bought the following today -

Russia (RSX) stop buy at $14.15
200% Long Financials (UYG) stop buy at $8.25
200% Long Dow Jones Industrial Average (DDM) stop buy at $31.50

DDM was sold today on a stop loss at $32.75

I bought too early today. I had a stop in on DDM at $29.75 and raised it 3 times in the last hour today before stopping out for a decent profit.

I have been keying all of my trading activity off of the action of the Dow Jones Average. I have learned to do this, because it tends to lead all moves and temds be the most efficient in pricing these moves. Moreover, I believe that when the Fed ("The President's Working Group on the Markets" or "Plunge Protection Team") decides to accelerate the futures programs, they tend to focus their buying on the Dow Jones.

So if the Fed uses the Dow Jones to drive market action, then who am I to do otherwise with planning how to deploy my money...

Chart School 101
When entering a position, I use standard deviations away from the 260 period moving average on the 30 minute chart. I plot the 0.5, 1.0, 1.5, 2.0, 2.5 and 3.0 Bands above and below the 260 period EMA. These are referred to as Bollinger Bands for the guy who first created them.

Price is generally at extremes when it nears the +/- 3.0 Band. That is when you are looking for reversal patterns for a change in trend.

The last 2 days of trading have been stuck between the -1.0 Band (Pink Line) and the -1.5 Band (Purple Line). The Fibonnacci Lines and the uptrend line from the 10/10 low has also been in play.

Do you still think stocks are a "Random Walk"?
I will either be looking to sell a rally of the Dow into the 8,750 - 8,800 range, or I will get stopped out of holdings on selling tomorrow morning.
I would love to see the Dow hang around the 8,600 - 8,700 range for a few hours tomorrow and then break out or fail on big volume.
I am assuming a positive bias tomorrow. I just don't think the Fed wants the markets to fall hard on a Friday in October and set up the potential for a panic Crash on Monday. We'll see.

Wednesday, October 22, 2008

Understanding Charts 101

The current market is acting as if it were a lesson in a book on how to trade stocks. I am not sure why this is, but I think it is because the only guys left in the markets right now are people who need to sell and traders who are trying to make a few bucks each day.

Fibonacci Levels
If you read books on how to trade using stock charts, you are taught that markets tend to retrace specific percentages of a move before they initiate a new move. These levels are called Fibonacci Levels and are 38.2%, 50%, 62.8% and 76.4% of the low to high or high to low of the last move.

Trend Lines
Trend lines are essentially where you play connect the dots between the tops of a trend or the bottoms of a trend. The line formed by the tops becomes resistance and the line formed by the bottom becomes support.

Consolidation Patterns
Periods were the markets trade in a tight range are called consolidations. These times of low volatility trading normally appear as triangles, flags, rectangles or wedges. Consolidations are normally followed by violent moves. They normally appear as a pause within a strong trend. So a violent move in one direction is followed by a consolidation pattern and then another violent move occurs in the same direction of the move which preceded the consolidation.

So why am I boring you with this stuff?
Again, because the markets are trading as if the charts are lessons in a book. I want to show this to you so all you can get an understanding of how institutional traders make a living.

Moreover, because I have an understanding of this stuff, I am able to manage risk by knowing when I have a high probability of making money and when I should be getting out of the way. Also, I don’t overreact when the market makes big moves one way or the other, because I know where the high probability reversal levels are.

Take a look at the Dow Jones since the 10/10/2008 low –
See how the tops were getting lower and the bottoms were getting higher (green lines)? That was telling me to be ready for a big move in one direction or the other.

The Dow spent the majority of 10/21 between 9004 (50%) and 9270 (61.8%).

Now take a look at how the market traded today! You can’t make this stuff up.
On this chart I have included the retracement levels from the 10/10 low to the 10/13 high (Blue Lines).
When the Dow Jones finally broke below 9,004, it then sold off 200 points in 15 minutes (Red Arrow)!
When the Dow took out 8,608, it sold off 275 points in about 20 minutes (Blue Arrow).
I figured that the 76.4% level of 8,328 (Blue Line and Purple Arrow) would come into play today on any break of 8608, and was ready to start to lock in profitable short positions at that level. The problem was that a hell of a lot of other traders had the same idea and the Dow rallied about 280 points in 12 minutes!
Guess where the rally stopped? That’s right, the rally stopped right at the broken uptrend line (Green Arrow), or 8,552.

The only question is how does the market open up tomorrow?
My guess is that the Dow will open tomorrow at or about 8,610. That would set an interesting wrestling match between 8,610 and 8,552. Maybe we get some new bailout package from the Fed over night and the market gaps up hard above 8,833. Nothing these days surprises me.

A Detailed Review of Today's Trading

I want to show you some trades I did today to give you an idea of how this market could be traded. I came into today short the Dow (via DXD) and short the Oil Sector (via DUG). I got lucky and walked into a sharply lower open, with DUG up about 10% and DXD up 5%. I sold both holdings in the first few minutes of trading.

My goal today was to wait for the market to trade in these consolidation patterns and then buy or short the market based on how the market moved.

Here is a chart of the Dow Jones over the past two days -

The consolidation of 10-21 was taken out of play, because when the Dow started trading on 10-22, it opened -200 points lower than it closed on 10-21. I closed out my positions in DXD and DUG quickly, because I thought the markets would have a bigger bounce from 8,833 (top Blue Line) than actually materialized.

The Dow hit the 61.8% retracement line at 8,620 and then spent most of 10-22 trading between the two blue lines. The triangle pattern formed and I chose to short the market on a break of the triangle (Orange Arrow). I figured that a test of the green line would materialize on 10-22 or 10-23, and was willing to wait for it to do so. However, I got a bonus in that the selling carried all the way down to 8,335 (Green Arrow)!

I was able to cover some of my shorts, but the market rallied up 250 points in 12 minutes and I was not able to get all my shorts covered in those few minutes when I really liked the prices I was getting.

I shorted the market via the following at about 1:10 pm EDT -

-200% Inverse Emerging Markets – EEV at $150.5
-200% Inverse Financials – SKF at $142
-200% Inverse Materials – SMN at $85.5
-200% Inverse S&P 500 – SDS at $87.50

Here is a daily chart of the Dow. Two things stick out –

1. At some point price will catch up to the black line. It always does. The question is does price rally sharply to touch the line, does the line implode lower to catch price or do they meet somewhere in the middle?

2. The Dow is in a 2,200-point triangle (Green Lines). This is a classic consolidation after a 3,000 point selloff. A break of this pattern would target 6,300 on the downside. Holy cow! I do not make price target predictions. I am just trying to give you an idea of the potential magnitude of the next move.

I am not certain which way the Dow breaks (up or down), but I am fairly confident that it will move up or down with tremendous violence in the not too distant future.

I want in on that move!!

The Market is ALWAYS Right!

If you ever hear a Money Manager say the following, ask him for your money back immediately –

“The market is wrong”

The market is NEVER wrong. EVER!

After a great deal of studying, I determined that there was a high probability that money would again flow into the inflation/leverage trades in the very near future. I figured that the driver would be a successful cash settlement of the Lehman CDS holdings at banks.

Well, Lehman CDS settled without a hitch and what happened? The Dow sold off 400 points in the first 30 minutes of trading this morning. The market is always right, so I took defensive action.

Last week I started to take small positions in front of the Lehman CDS settlement. Here is what I bought and what I paid (average) –

5% Natural Gas (UNG) $30.50 limit
5% Euro (FXE) $133.50 limit
5% Russia (RSX) $16.10 limit
5% Gold (GGN) stop buy at $11.50 never triggered
5% Swiss Franc (FXF) stop buy at $88.5, then $86.8 never triggered

Here are my stop loss limits -

UNG stop loss $30 triggered today
FXE stop loss $128.25 not triggered yet
RSX stop loss $14.55 not triggered yet

I cancelled all buy orders on GGN and FXF.

So the likely maximum I will lose on these trades is a whopping 0.755% for clients.
I think it was worth the risk to try and make a BIG gain.

The bottom line is this – IT IS OKAY TO BE WRONG, BUT IT IS NOT OKAY TO STAY WRONG!!!!

With the Bearish action today, I went short a mix of the following for clients and myself –

Financials (SKF)
Emerging Markets (EEV)
Materials (SMN)

I may end up covering my short positions as early as tomorrow morning.

Tuesday, October 21, 2008

Earnings Releases for the Banks with Massive Derivative and no Bailout

In the past few days, earnings have been announced by 7 of the 9 remaining banks which have massive derivative exposure, but haven't yet been bailed out by a Central Bank, and the earnings have been horrible.

National City (NCC) #14
The lasted earnings (8K released 10/21/2008) can be found here -

The release is 129 pages! Oh my. In an effort to protect clients' assets, I have learned how to decypher these things , as in the past 18 months I have been forced to read everything from Level III asset filings to Money Market Fund Prospectuses.

The management of National City can say what they want and try and manipulate the "market to market pricing" of vast swaths of their assets to goose their earnings higher, but here is what I see for NCC -

Market Capitalization $6.47 billion
Non-performing Assets $3.537 billion
Home Equity Lines and Loans $15.8 billion (page 75)
Total Loans $111.2 billion (these are "assets" on the books of banks)

So an equivalent of 3.2% of their loans have already been written off as total losses. If real estate prices fall a little further (highly likely), or credit cards delinquencies rise (highly likely) or they "mispriced" there assets be even a little bit (remember when Merrill Lynch sold that $30 billion bond portfolio for an effective price of 5.8 cents on the dollar a few months ago) (highly likely), then NCC will take a large enough loss to wipe out ALL of their equity and be insolvent!

Take a look at what people who had their money managed by NCC did the past quarter -

Assets under management -
Equities down -58% in the most recent quarter (page 68)
Bonds down -26% in the same quarter (page 68)

They pulled their money out. They clearly were nervous enough to move their money.

My big concern is that NCC has over $110 billion in derivative exposure (394% of what Lehman had). If National City were to go out of business (which seems like a real possibility after reading the 8K filing), then the markets would melt down yet again.

The Fed/US Treasury gets this and in my opinion will not allow National City to fail. I think NCC will either get nationalized or bought by a larger bank in the not too distant future. I have no clue whether they get bought out for a premium or a discount to the current price and personally choose to avoid all exposure to anything bank related.

US Bancorp (USB) #15
USB may another train wreck waiting to happen, with a $87.448 billion derivative portfolio.
This quarter, the delinquency rates on their loan portfolio increased markedly (pages 43 of 46).

The one think US Bank has going for it is that their new worth is enormous ($54 billion) when compared to the other names on this list.

So USB may end up being a buyer of other banks, and not get taken over or sold at a deep discount. Again, I do not own it and have no intention of doing so. Buy it or short it at your own risk!!

Fifth Third Bank (FITB) #20
Same story as NCC, but the release is only 14 pages -

PNC Financial (PNC) #10 and BB&T (BBT) #17
Seems to be more in the camp of US Bank. I think they will be buyers and not sellers. Just a guess, but we'll see. Same disclaimer as above...

Remember, they can only by buyers if the Fed gives them big piles of money. So expect these guys to get bailed out. In Fed Speak, it will be a "injection of capital" in the form of the Fed buying preferred stock "at no risk to the taxpayer".

Keycorp (KEY) #13 and Regions Financial (RF) #16

The 2 stragglers are Suntrust (STI) #9 and Northern Trust (NTFS) #11
In my opinion, these are coin flips are to whether they are acquirers or acquirees.
Time will tell, but we should know in the next few months who the survivors with massive derivative exposure are. Then the giant game of "Go Fish" will begin!