of thesame industry or sector would be Best Buy versus Circuit City, as shown in
FIGURE 1.6RealTick graphics used with permission of Townsend Analytics, LTD.
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Figure 1.7. As consumers flocked to retail malls before the holidays to purchase gifts such as Apple’s iPods, if you want long Best Buy as the sectorleader and short Circuit City, Best Buy stock outperformed Citcuit Citystock. As you can see from the chart, after the stock market bubble burst in2000, Best Buy managed to maintain a positive trend higher. It is the leadership of the company and the consumer loyalty that really have helped tosupport this company’s growth and profitability. One reason is Best Buycontinued to sell appliances versus one of their rival competitors and as aresult they saw sales rise 7.7 percent from 2004 through 2005. They also hadaggressive gains in web sales, and online revenue jumped 40 percent asmore customers shopped and redeemed gift cards online for the same timeperiod.Best Buy’s main competitor, Circuit City, decided or needed to cut backand close stores and then discontinued selling appliances to stay afloat. Itdepended on increasing DVD and CD sales and on electronic products. Asthe housing boom materialized soon after that decision, Circuit City gaveup market share to Best Buy; and no doubt companies such as Home Depotand Sears picked up increased revenues in appliance sales. Therefore, it
FIGURE 1.7RealTick graphics used with permission of Townsend Analytics, LTD.
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FIGURE 1.8RealTick graphics used with permission of Townsend Analytics, LTD.
was hard for Circuit City to reenter selling that product line. As you can seein Figure 1.8, Circuit City’s stock just had not been a great performer in thatsector. The company was founded in 1949, so it has a long history and maysurvive the competition. However, if consumers start to spend less onhome electronic products in 2006 and 2007, this company may have troublegetting its stock price back up to the 2000 high near 65 per share. CircuitCity will need consumers to continue to buy and upgrade new televisions,camcorders, and digital cameras to boost revenues. I personally have no intentions of buying another camcorder; I barely use the one I have. As forgame software, game hardware, and personal computer software, those arecompetitive products; so I believe Circuit City will have to do more to survive the next few years of what is being forecast as a consumer electronicsales recession. Therefore, one would need to look closer at these two companies and decide which one has more to gain or which one has more tolose; once a decision is made, this would be a good pairs market for aspreading strategy.Investors have many trading opportunities with stocks, as you can see
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from the preceding few pages. There are many ways to analyze a company,from taking a simple look at the P/E ratio to using technical analysis studies. Investors can see which company is the leader in a specific sector andinvest with that leader. As you can see in the cases of Apple versus Dell andBest Buy versus Circuit City, holding a diversified portfolio of stocks mayhelp investors see profits or a positive cash flow. Realistically, you can’town shares in every stock. Longer-term investing—you know, the buy-andhold mentality, sometimes referred to as the Warren Buffett method—helpstoward generating big gains in solid companies. But remember that WorldCom and even Lucent Technologies were solid companies at one point. Sothe message here is that investors need not only to be selective in whichmarkets they buy and hold but also to monitor their positions. There is theidea that you can buy stock in a company to which you relate or from whichyou purchase products . . . companies like Starbucks, as shown in Figure1.9. This company has solid growth, great coffee; it carries with each 20ounce cup, named a Vente, a solid jolt of caffeine. That is what keeps megoing back, day after day, dropping two dollars per cup for the Starbucks“experience.” Starbucks has made stellar gains and is a great moneymaking
FIGURE 1.9RealTick graphics used with permission of Townsend Analytics, LTD.
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stock. It has solid industry leadership, textbook marketing concepts, and,more important, customer loyalty. These are all the qualities to look forwhen selecting a long-term purchase.
BECOME THE NEXT WARREN BUFFETTI believe that stocks should be traded as an investment, but there are manyways to capture a profit. I must say for all investors and for every trader,you can start your own mutual fund. It requires discipline not only to opena stock account but also to fund it and add to it every month. If you are anew investor, just reading this book to see if trading for a living is for you,it is imperative that you start somewhere and start with a select stock account first. The discipline is that you should add money in the accountevery month, like you are paying a bill. If you are under 30, consider it yourretirement. You are paying your bills in the future now. That is some of thebest advice anyone gave me, and I think it is worthy of passing on to you.Once you gain more experience, you can separate long-term investing fromshort-term speculative trading, which is one form of diversification. Afterall, you may see a long period of flat performance in one of your core holdings. Short-term day trading, if you have the time and resources, can be a rewarding experience. Imagine owning Wal-Mart and for literally seven yearsexperiencing a loss to a flat performance. Figure 1.10 illustrates the market’s sideways move in one of the world’s biggest retail stores.If you are considering supplementing your investment techniques, oneof the many drawbacks of trading stocks for a short-term day trader with asmall trading account is that you are limited to how many trades you canmake, especially if your account is less than $25,000 and you are not signedup for a margin account. In that case, you are limited to five round-trip buyand-sell trades per week due to SEC rules. So short-term trading would notbe a good consideration for stocks. That is where trading stock index futures and forex markets takes over, as I will explain in the following pages.There is one high-risk, high-reward method of trading stocks that I havenot covered yet: getting in on an initial public offering (IPO) stock. Thoseinvestors lucky enough to get in on an IPO like Google (goog), the ChicagoMercantile Exchange (CME), or even the Chicago Board of Trade (CBOT—stock, BOT) were able to double, triple, quadruple, or even better, their initial investment dollars.The Chicago Board of Trade has been around for over 155 years, and Iimagine it will likely continue to be around for another 155 years, with little competition in products traded on its exchange and with the increase inpopularity on the electronics metals products, such as gold and silver, plus
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FIGURE 1.10RealTick graphics used with permission of Townsend Analytics, LTD.
the huge volume of trades generated in the grain markets. And with the action in the U.S. Treasury notes and bonds and Federal (Fed) funds contracts, the CBOT certainly has a positive longer-term outlook for profitablerevenue growth. Figure 1.11 shows that the price exploded to nearly ashigh as 134 but has managed to trade back as low as 86 as of this writing.The BOT stock illustrates that not all IPOs are guaranteed moneymakers; infact, depending on your entry, these offerings can be hazardous to your financial well-being. The phrase “invest wisely” means “not putting all youreggs in one basket.” Find out which is the sector leader, and go with thatstock, unless you like the underdog. In this case, the underdog would beBOT compared to CME.As you can see in Figure 1.11, BOT stock initially shot up from the 80sto a little over 130. At the time I was preparing to write this book, it had notmanaged to get back over 130 but traded as high as 119. I do feel that oncethe Treasury reinstates issuing the 30-year Treasury bond, volume will increase, which will translate into more revenue for the exchange. Therefore, the profitability should improve through the next few years. If adrought scare causes the grain complex to go through the roof, you will see
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FIGURE 1.11RealTick graphics used with permission of Townsend Analytics, LTD.
this stock price move like a rocket. Many see the Chicago Board of Trademimicking the Chicago Mercantile Exchange success story. As Figure 1.12shows, in just three short years, CME stock went from under 40 to close to400 by late November 2005.The biggest surprise of the three had to be the gains by Google, asFigure 1.13 shows. After the dot-com implosion in 2001, not many werewilling to experiment with any Internet stock. That mentality may be theone reason why this stock had such a move, from a contrarian point ofview, that is.
LONG-TERM INVESTING OR SHORT-TERM TRADINGWe have briefly covered ways to trade stocks and certain methods to tradeleaders of stocks in certain sectors. Investing carries less stress, fewer dayto-day decisions, and less risk than trading does; and with that come fewerrewards. Just as we all have different personalities, there are that manyopinions on how to trade the markets.
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FIGURE 1.12RealTick graphics used with permission of Townsend Analytics, LTD.
Some of the keys to successful trading are:• Diversification. This not only applies to markets, such as a wide assortment of stocks in a portfolio, but also to trading different strategiesand various investment instruments.• Risk Management. Profitable trading also comes from skills acquiredfrom practicing discipline, patience, and risk management techniquesthat preserve your capital.• Behavior or Emotions. Successful trading means removing the mostdestructive element, negative emotional feelings that plague investorswhen trading: fear, greed, and anxiety. Finding the right mixture of investment products and trading styles can teach you to feel secure whentrading.The methods we cover in this book can be applied to the topic of selecting stock and spread trading, as we just covered, and to long-term-position trading, as in the style of trading for which Warren Buffett is famous.
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FIGURE 1.13RealTick graphics used with permission of Townsend Analytics, LTD.
EXCHANGE TRADED FUNDSExchange traded funds (ETFs) are listed on different exchanges and aretraded on the open market. Choosing this kind of product allows an investor to select the right sector of performance, rather than pinpointing anindividual stock. The benefits of trading ETFs compared to a mutual fundare enormous: They allow diversification; they incur more effective transaction costs; there is pricing transparency; and they are tax efficient. Afterall, it is almost impossible for an individual trader with limited trading resources to effectively track and trade every stock in all sectors of the market. ETFs are index-based investment vehicles and are traded as a share ofa single security based on an entire portfolio of stocks. The advantage hereis that the trader can mix the benefits of applying technical analysis andfundamental analysis to a combination of stock and index trading.In the most recent development, ETFs have started to include productsrelated to commodities such as crude oil, gold, and silver; but also theyhave expanded into the forex arena by launching a euro currency product.
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Personalized Mini-Mutual FundInstead of agonizing over which stock will outperform in a certain sector,you can use ETFs as an investment vehicle that has certain stocks in a basket as one unit, listed as a sector fund. This allows individual investors toinvest in a group of stocks in a sector, rather than relying on a mutual fundto do it for them. Moreover, many mutual funds charge management feesand at times do not fully invest all an investor’s cash in the market. BecauseETFs trade like a stock, the price of which fluctuates daily, an ETF does nothave its net asset value (NAV) calculated every day like a mutual fund. Byowning an ETF, you get the diversification of an index fund plus the abilityto sell short, buy on margin, and purchase as little as one share.Another advantage of an ETF is that the expense ratios for most ETFsare lower than that of the average mutual fund. When buying and sellingETFs, you have to pay the same commission to your broker that you’d payon any regular order. ETFs allow you to sell without the uptick rule, so youcan short right away, even after the market is in a strong downtrend. You donot have to wait until the close of the day settlement price as happens in amutual fund. Another benefit is the tax consequences because of shieldingfrom capital gains due to the fact that ETFs do not change holding like amutual fund does. So purchasing shares of ETFs is a viable alternative toinvesting in mutual funds for individual investors. Keep in mind that manyof the ETFs available today have access to trading options around the ETF.Therefore, you can develop simple or more complex hedge or spreadingstrategies tied around an ETF. There are some negatives, such as the threeday settlement restriction and a bid/ask spread just like any other market;but the benefits certainly outweigh the negatives, especially for longer-termswing and position traders.
The Birth of ETFsThe original ETF was offered to the investing public back in 1993 by theAmerican Stock Exchange (go to www.amex.com for more listings) andwas known as the SPDRs, which stands for Standard & Poor’s DepositaryReceipts and corresponds with the price movements of the Standard &Poor’s 500.The more actively traded and by far more popular ETF came with theQQQs, which directly correspond with the Nasdaq 100. Then there are theDiamonds, which move in correlation to the Dow Jones Industrial Average.ETFs have since expanded, and there is now a new breed of investment vehicles to capture opportunities in sectors known as HOLDRs. These tradingvehicles are based on certain stocks in a certain sector, known as a basketof diversified stocks in a specific sector.
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Just as the examples comparing the U.S. Real Estate Trust (IYR) shownin Figure 1.14 to Toll Brothers, ETFs can offer investors a relationship tooverall sector performance that is better than outright exposure in just onestock if you are wrong in your investment decision. As we go forward in thebook, I will show you a technical analysis method such as pivot pointsusing a longer-term time frame and how it can help you determine entryand exit targets, such as targeting almost the exact high in Toll Brothers, aswell as other stocks.As you can see in the comparison of the two charts in Figure 1.15, TollBrothers took a nasty hit while the Real Estate Investment Trust ETF rebounded from the correction.Looking at a related or similar stock, such as Caterpillar in Figure 1.16,you would assume that if the construction or housing and real estate markets could experience a setback due to the 14 interest rate hikes orchestrated by the Federal Reserve, then a company that manufacturesconstruction and heavy equipment might suffer a significant correction as
FIGURE 1.14RealTick graphics used with permission of Townsend Analytics, LTD.
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FIGURE 1.15RealTick graphics used with permission of Townsend Analytics, LTD.
well. However, that was not the case, as the chart illustrates. In fact, it isquite the opposite. So by utilizing an ETF and investing in an overall sector,an investor has a better chance of gaining a better rate of return. By usingthe technical analysis methods that will be covered in this book, an investorcan apply those signals to ETF markets. Keep in mind that options willeventually be available for most ETFs as well. That will offer investors quitean edge as far as hedging or protecting against adverse market moves, too.
Hot Sectors, Hot StocksIn order to take advantage of a hot sector of the market, such as energy,biotechnology, technology, Internet, brokers, semiconductors, telecom,and cyclical, to name a few, how would an investor identify the best stocksin that sector and then narrow it down to one or two stocks and be right?That is generally the tough part of investing. Trading an ETF or a HOLDRcan help remove that difficulty and may help a longer-term investor achievethat goal. Moreover, it can also allow an individual to literally trade like ahedge fund through means of diversified sectors and allow for implement-
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FIGURE 1.16RealTick graphics used with permission of Townsend Analytics, LTD.
ing simple to sophisticated trading strategies integrating options as statedearlier. With market liquidity and market transparency, traders using ETFscan buy or sell at current market values rather than at assigned market values based on the close, as is the case when investing in mutual funds. Infact, some mutual funds may not be fully vested in stocks at a given time.This means your cash may not be working at 100 percent capacity.
Currency ETFsThis book will also reveal more about the forex markets or foreign currency trading. And on that subject, there was a new ETF that may appeal tothose who want to participate in currency investing but have neither thetime capacity nor the desire for excessive leverage exposure. Rydex Investments launched the first-ever currency-based exchange-traded product back in December 2005.The Euro Currency Trust (FXE) is an ETF that tracks the price of theeuro, with each share representing about 100 euros plus accrued interest.Shares of the trust, called “Euro Currency shares,” trade on the New York
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Stock Exchange (NYSE). The ETF has a 0.4 percent annual fee. Investorsgenerally pay commissions to buy and sell ETFs, which trade daily on exchanges as stocks do. Initially, the trust registered 17 million Euro Currency shares, for a total offering price of about $2 billion. Shares of the ETFcan be sold short and are eligible for margin, as most ETFs are. Notice thecorrelation of price movement in the ETF shown in Figure 1.17 with theeuro FX currency futures contract shown in Figure 1.18.Granted there is more liquidity in the price of the euro futures contract;but keep in mind the that the euro ETF was in its third week of trading afterits initial launch date. I suspect that by the time this book is published, thevolume and liquidity will improve dramatically.
Commodity ETFsNot all ETFs track the price movement of the underlying derivative marketexactly. Take for example the OIH chart shown in Figure 1.19. As you com-
FIGURE 1.17RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 1.18RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 1.19RealTick graphics used with permission of Townsend Analytics, LTD.
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pare moves in the underlying commodity of crude oil, as shown in Figure1.20, you will see that at times the correlation is not 100 percent exact. Infact, at times the ETF has actually been a leading price indicator of the underlying commodity price move! Now there is an ETF that is more closelycorrelated to crude oil, such as the United States Oil Fund (USO).The example in Figure 1.21 is streetTRACKS Gold ETF, traded on theNYSE. It was launched in late 2004; and as of December 2005, when Istarted writing this book, it was trading roughly 2.1 million shares a day. Ithas attracted $5.65 billion from investors. Each share of the ETF represents one-tenth of an ounce of gold, which allows mutual funds or privateinvestors to invest in gold without actually owning the metal. It mirrors ortracks the price movement of gold almost exactly, as you can see from Figure 1.21 when compared to the gold futures chart in Figure 1.22.The objective of the trust is for the value of its shares to reflect at anygiven time the price of gold owned by the trust at that time, minusthe trust’s expenses and liabilities. The trust is not actively managed. It receives gold deposited with it in exchange for the creation of baskets ofiShares. The trust sells gold as necessary to cover the trust’s liabilities, and
FIGURE 1.20RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 1.21RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 1.22RealTick graphics used with permission of Townsend Analytics, LTD.
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it delivers gold in exchange for baskets of iShares surrendered to it for redemption. The trust is not an investment company registered under the Investment Company Act of 1940 nor a commodity pool for purposes of theCommodity Exchange Act. This is traded on the American Stock Exchange(AMEX).Figure 1.22 shows the CBOT gold minicontract; and as you can see asyou compare the two charts, the price movement in the gold ETF shown inFigure 1.21 mirrors almost exactly the price movement in the gold futurescontract.For silver bulls, bears, or spread traders, the newest ETF addition wasthe AMEX iShares Silver Trust (SLV). It is a fund based on the daily price ofone ounce of silver as set by the London Bullion Market Association. Thosespread traders buying gold or selling silver now can use ETFs. The key inshowing you the various markets as compared to the ETFs is that you realize that once you identify the opportunity, you then can make a good decision on which opportunity best presents itself. While futures offer theleverage, you may want to invest longer term; and an ETF would be right upyour alley without having to pick a gold or silver mining stock. If you arebullish on precious metals but don’t want to buy the physical metal and ifyou have the luxury to trade options, then an ETF would be the rightchoice.It does not go without saying that an outright stock selection can provide a great return and can at times outperform the sector and even the underlying market. Look at the price move for Newmont Mining in Figure1.23. This stock took off and never looked back, even when the price ofgold and the gold ETF made a price correction. There are times when thatcan happen. Even if you were to purchase long call options, the most profitable rate of return comes from the leverage of an outright long call optionposition in a straight up move, such as Newmont experienced. The questionis how many times can that trade and, more important, the timing of suchan event be replicated.Another advantage of an ETF is the availability and structured use ofiShares. If you are trying to match the most liquid investment vehicle witha specific sector or group of like stocks, this may be the right investmentchoice. IShares are considered to be like an open-ended mutual fund thatreinvests dividends. This investment class is always fully invested in themarket; so when the market moves up and you are long, you would fullybenefit. These index funds also trade just like stocks. Each fund share represents a proportion of ownership in each stock that makes up the index.As we have briefly discussed, to make the right choice in an investment andchoose the right stock, you can utilize fundamental analysis, such as earnings per share and market capitalization, to determine what the potentialfutures earnings might be. This data can help you determine if the stock is
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FIGURE 1.23RealTick graphics used with permission of Townsend Analytics, LTD.
ripe as a buying opportunity or if the price is too high or overvalued andshould be avoided. Considerations that can never be determined are thehidden demand for a company’s product and the way the company is run,to see if the profit margins are high or if operating costs and deep discountsto retailers cut into the company’s bottom line. Therefore, it could be prudent to possibly play the sector through an ETF, which effectively wouldeliminate the issue of selecting the wrong stock or the underperformer ofthat specific sector.
The Hot StockTake, for example, one of the most amazing come-from-behind stories in2005 and early 2006. Advance Micro Devices (AMD) triumphed, surpassingIntel’s price level. It would have taken patience and discipline to stick withthis winner; but outperform it did, and what a hot stock it was, as the chartshows in Figure 1.24!For a specific ETF or iShare that would list AMD and Intel, you wouldlook at the iShares Goldman Sachs Semiconductor (IGW) listing. The top 10
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FIGURE 1.24RealTick graphics used with permission of Townsend Analytics, LTD.
holdings as of 12/31/2005 were Texas Instruments, Intel, Motorola, AppliedMaterials, STMicroelectronics NV, Marvell, Technology Analog Devices,Broadcom, Advanced Micro Devices, and Maxim Integrated Products.Intel was a darling among institutional traders and mutual funds, but ithad not performed well, let alone offered enough volatility to day trade oreven swing trade a position. There was just not enough movement in thisstock, as Figure 1.25 shows.So how was an investor to make money, and how would one possiblychoose to invest in AMD instead of Intel? Actually, once a few simple concepts of identifying market price momentum through candle charts are covered in the next few chapters, you will see how and why to stick aroundwhen a market goes into a trending phase. Also, once you learn these techniques, it will be pretty easy to help select the right stock. Another simpleinvestment decision would be to buy the iShares Goldman Sachs Semiconductor ETF! As you can see from Figure 1.26, the semiconductor ETFmoved up. It would have been a far better trade simply being outright longAMD from under 15 in March 2005, but the torture of watching Intel gonowhere would have been a reason to buy the semiconductor ETF and
FIGURE 1.25RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 1.26RealTick graphics used with permission of Townsend Analytics, LTD.
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participate in a profit. The key in using these vehicles is for those who like aspecific sector and do not have unlimited resources to buy a wide spectrumof stocks. It is also appealing to those who want longer-term trades and whohold a regular day job and cannot day trade for a living, at least not yet.Once again, the difficulty of choosing the right stock in a competitiveindustry in a specific sector can be overcome; and it may be more profitableby considering trading an ETF. The previous comparisons of Best Buy andCircuit City, Dell and Apple, and AMD and Intel all are excellent examplesof how an investor may have a difficult time anticipating which stock outperforms another in a specific sector. Therefore, for a longer-term stocktrader, ETF investment vehicles could be a solution, helping to boost thebottom line, and can be added to his or her investment portfolio.ETFs and some HOLDRs have the greater advantage of trading put andcall options within a prescribed period of time. An investor can even buycalls such as on the pharmaceutical HOLDRs. Here is a tactic that I haveused before with some success, especially if there are buy signals on several individual stocks within a sector. Go ahead and purchase, with a reasonable time until expiration, an in-the-money or close-to-the-money calloption on the HOLDR itself. The pharmaceutical HOLDRs can be tradedbased on signals from Abbott, Merck, and Pfizer.So you can utilize ETFs and their respected relatives and apply severalstrategies; also you can use intermarket relationships to determine buy orsell signals and devise a trading strategy dependent on those signals. Onceyou have a good feel for a stock that correlates or links best with anETF, then you can use a spread or “pairs” trading strategy or even a hedgestrategy using options. Deciding what is best for your risk capital making,using an ETF, you no longer need to make a precise pick for a stock in aspecific sector.In conclusion, trading opportunities exist in these investment vehiclesfor all investors; and best of all, they respond quite well using technicalanalysis to project support and resistance levels as derived from pivot pointanalysis and the momentum techniques that certain candle patterns indicate, which are the specific techniques disclosed in this book. This knowledge should give you, the individual investor, quite an edge in the market!
FUTURES MARKETS: LEVERAGE SYSTEMWe will go over several techniques for helping you identify trading opportunities in the futures markets. So far we have gone over using exchangetraded funds versus stocks; pairs trading in related stocks; and usingcommodities for identifying opportunities in ETFs, such as the oil service
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HOLDRs (OIH) or the U.S. Oil Fund (USO) versus crude oil futures. TheEuro Currency Trust (FXE) is a more direct move for stock traders playingthe euro currency futures versus the U.S. dollar. Then there is the streetTRACKS Gold ETF (GLD) compared to the CBOT electronic gold futurescontract, or now a trader can use the iShares Silver Trust to trade againstthe physical silver market.Stock traders can now apply and take advantage of so many commodity markets; but as I mentioned, the futures market is a great investment vehicle to many savvy and financially well-funded traders. Even smaller-sizedtraders can benefit from trading the futures market through the responsible use of the margin system, otherwise referred to as a “good faith deposit.” What is a futures contract? It is a legally binding agreement to buyand sell a commodity or financial instrument sometime in the future at aprice agreed upon at the time a transaction was made. Contracts are standardized according to delivery points of interest, quality, quantity, and timeof accepting or making a delivery. It is estimated that less than 3 percent ofall transactions actually result in a delivery. In the case of stock index trading, there is a cash settlement over the value of the contract.
Stock Index FuturesFor day or swing traders following the stock market, the futures marketoffers an advantage over stocks from tax liability perspective. Alwayscheck with your accountant; but, generally speaking, profits generated ina futures account are taxed at a rate significantly lower than that for astock account.One confusing aspect and perhaps a drawback for many tradersswitching from equities or even forex to trading futures is that there are somany products with various contract