IBD Meetup Group Night

Tonight was Investor’s Business Daily Meetup Group night.   Investors all over the world who are interested in IBD trading strategies can meet on the last Wednesday of each month to share their insights on investing and trading.   Tonight, about nine of us met at a local restaurant.   There is a core group of regulars with a few newcomers attending once in a while. Tonight it was all experienced members who are fairly addicted to trading the market.   We all study stock charts, read IBD, and use many of the IBD investing tools.

Tonight’s meeting was different than the other meetings   that I have attended during the past year.   No one circulated piles of charts of promising industries or stocks to buy.   The discussions were subdued and everyone said that no one was making much money trading. They were licking their wounds and lamenting that this   was the worst market in a long time.

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The Downtrend Continues?

“Want to know how to make a small fortune in the stock market?
Start with a large fortune!”

I thought you would probably want me to back off of the strategy discussion (see yesterday’s post) and to return to my take on the market.   A number of people have written to me about going short.   This interest, together with the skepticism about the market’s rally in the media cause me to pause, just a little.   However, I do not reverse direction until my market indicators start to change. So, I wait, mainly in cash and put options in my IRA.   (I did sell my one small long position, MHS–I got tired of holding anything at odds with the general market trend.) The attached chart (click on it to enlarge) Irxx shows the consistent rising trend in short term interest rates that started in May, 2004. (I have asked the TC2005 support staff at Worden.com to tell me the basis for this index, and will report back on their answer.) The Fed’s persistent pressure on rates is one of the obstacles to a rising market.   Historically, in its fear of inflation, the Fed typically misjudges how much to put on the brakes and eventually brings the market and the economy to a screeching halt.   (In spite of this track record, traders tend to delude themselves into thinking that this time will be different and we will get a “soft landing.”) This short term interest rate index has been hugging its rising 10 week moving average for months, and just bounced off of the average to a new high, after a few weeks of a plateau.   This renewed rise is not a good omen.   A consistent reversal in this index will probably foreshadow a subsequent bottom in the market–but not immediately.   So, we will keep an eye on this index.

IBD’s Monday edition published a put/call ratio of   .86.   This means that 86 puts were traded for every 100 calls.   (Puts are options that gain when the underlying security falls; calls gain as a security rises.   In other words, puts are bets by option traders that a security will fall, calls are bets on a rise.   Did I imply that people are gambling?)   This ratio is a contrarian indicator, which means that it typically predicts the opposite type of   market movement than would be expected from the trades.   If an extremely high number of option traders are bearish (buying more   puts than calls) then the market often tends to rise, at least short term.   People are most scared at bottoms and overly optimistic at tops.   Most of the time, traders are more bullish than bearish and the p/c ratio is below .80.   When it stays above .80 for a while and gets above 1.0, the market usually is in store for a bounce.   The current ratio is not at an extreme.   However, if it breaks 1.0 this week it may signal short term   strength in the market.   If the P/C ratio   starts to trend lower in this depressing environment, say below .60, watch out below!

I am short some housing stocks.   It is rare that I find so many companies in an industry with the charts looking so sick.   Here are a few, in no special order:   RYL,OHB,LR,LEN,MDC,MHO,DHOM,WCI,SPF,DHI.   I did not run out of ugly symbols, but you get the picture.   Even   lofty NVR appears to have broken its uptrend on a number of large volume declines.   Is it too late to sell these?   Who knows, but the current trend is obvious to me.   Could insiders possibly be showing us something about the future of housing?   Watch behavior,   not words.

I hope you have a good trading day tomorrow.   The trend is your friend.

WishingWealth 10 day successful new high index:   4/22 19;   4/21   28;   4/20   12 (for definition, see Madness post)

Put me on, IRA

Well, the market didn’t collapse today.  So what. Did you really think it would just tank like it did in 1987?    Most people hope it is over, and think that a further decline is not justified by the state of business, and especially, with all the bargains that have now materialized. However, the market always goes further than everyone thinks is justified–up or down.    This bear has plenty of time to smell the roses before it hibernates again.  It will take its own time.  Especially ominous–the short term interest rate index I follow jumped today–as much as it did when this rise in rates began in the first week of January.  Is something going to convince the Fed to become more aggressive?  Stay tuned.

Experienced traders do not care which way the market goes, as long as it moves in a trend.  Do you really believe the old adage, "Don’t sell America short?"  While the market spends most of the time going up, when we can buy stocks, why not profit in those periods of decline, when we can sell stocks short?  A good bear lasts 10 or more months and prices decline quicker than they go up–fear is quite a motivator. Why play only one side of the game.

Selling short scares people.  You ask your broker to borrow someone elses shares so you can sell them at the  current price.  He puts the proceeds in your account, but you can’t touch the money until you give back the shares you borrowed. When the stock falls, you buy the shares back at the lower price and give them back to the broker. You, however, get to keep the difference between the price you first sold the shares at and the subsequent buy back price (sell short at 80, buy back at 70–you make $10/share). What scares everyone is the idea that if the stock rises, you have to buy it back at a higher price and the price could theoretically go to a gazillion.  However, when you own a stock, the most it can fall is to zero.

Now, this fear of an infinite loss from a short sale is unrealistic.  When you buy a stock at, say 50, you place a stop order to  automatically sell your shares and "stop your loss" at an acceptable price, say 48.  If the stock falls to 48 you get sold out and take your loss.  You just reverse this for stocks you have sold short.  Sell short at 50, place a stop order to buy if the stock rises to 52.  Either way you have a strategy in place to limit your losses.  (Note, if the stock gaps up or down–jumps up or down in price and skips over your stop price–you may have a larger loss than your stop order would indicate.)

Now, to sell short I must trade in 100 share blocks in a margin account.  Margin, because the broker will charge me interest when he lends me the shares to sell short.  But I can’t trade on margin in my IRA account.  However, some brokers allow customers to trade options in an IRA.  Enter the Put option, IRA. 

A put option gives me the right to sell 100 shares to someone at a set price for a set time.  Thus, if I think stock XYZ, which is trading at 50 is going to decline, I could purchase a put option to sell 100 shares of XYZ at 50 (or 55, or 60 etc.) good for a few weeks or months.  I could then buy the stock, if it declines, to say, 45 and put them to someone at 50.  But I do not have to purchase the shares.  If XYZ declines, the put option (which trades like a stock on the option exchange) will increase in value and I can sell the option at a profit.  But if XYX rises, I can sell the option at a small loss or let it expire worthless.  Either way, if the stock rises, the most I can lose is the cost of the option.  So much for the myth of the infinite loss from selling short.

I can even buy put options on the stock market indexes (QQQQ, DIA) or ETF’s, if I think we are in a bear market–all in my IRA.  I cannot possibly cover all of the ins and outs of options here.  I am just trying to whet your appetite and show you how I profit from a declining market.  For a primer on options go to the learning center at www.cboe.com.  I disregard the media pundits looking for the rare rising stock to purchase and bet on the many stocks that are declining.