is a simple way of saying “Don’t fight the tape.”In this chapter, I want to focus on providing you with a few insights on how to profitin the markets by assessing market conditions and using the appropriate strategies forthese conditions. Since successful trading requires accurate identification of trends andapplication of the correct strategies to take advantage of these trends, you have to knowhow to use all the tools in your trading arsenal. Learning how to integrate these varioustools will enable you to increase your prowess as an investor or trader.Generally speaking, the market’s going to do one of three things: It’s going to goup, down, or sideways. Some studies have indicated it goes sideways roughly onethird of the time. When it reaches extreme levels, the trend will reverse direction.Since there are times when no one really knows which direction the markets aremoving, let’s take a moment to discuss various market conditions, how to recognizethem, and then figure out how to profit from them.
FUSING TWO METHODS: TECHNICALAND SENTIMENT ANALYSISWhen the only tool you have is a hammer, everything looks like a nail. With no disrespect to fundamental analysis, the best tools to work with when assessing current mar339
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ket conditions are technical analysis and sentiment indicators. Technical analysis provides chart patterns to help traders recognize critical price levels of support and resistance. These levels exert considerable influence on a stock’s movement and have asignificant effect on how and when a stock should subsequently be traded. Sentimentindicators can help pinpoint extremes in market psychology. Extreme levels of confidence and pessimism will help you identify tops and bottoms, respectively. This approach not only applies to the market overall, but to individual stocks as well.Fundamental analysis should be used to point out the financial strengths andweaknesses of a field of possible stocks. Even if you’re right about buying the stockwith the strongest management and the most efficient productivity, if you’re wrongabout market direction you’ll be entering a world of pain, comprised of sell-offs anddeclining portfolio valuations. So assuming we know what we want to buy, let’s figure out when to buy and when to sell.You need to recognize the trend before you startworrying about how happy or scared everyone is.
MARKET EVALUATION: TRENDS AND MARKET CONDITIONSThe first step in determining a stock’s direction is to look at the charts. Do you see atrend of any kind? Up and down trends are comprised of three main phases: major,intermediate, and near-term.• The major trend lasts a year or more.• The intermediate trend has a life expectancy of three to four weeks to three tofour months• The near-term trend describes short rallies or pullbacks that last less than threeweeks.Now look at the charts again. Can you spot a long-term trend? If you can’t, or needsome more hints, there are additional tools you can employ. But the first thing youneed to do is look at the market every day. Sometimes there will be a clear picture,sometimes not. Please take note: If the picture is unclear, or you’re unsure as to whattack to take, it’s best to sit on the sidelines in a cash position. A choppy or trendlessmarket is extremely difficult to make money in, even for the experienced trader.So if it is a sideways market, it’s best to sit it out. That leaves just two directionsto look for: up or down trends. Both of these trends can (and do) reverse, or continue on in the same direction after a pause. Therefore, being able to spot reversal orcontinuation patterns is an invaluable ability. Reversals don’t occur exclusively atthe culmination of a bear or bull market; they happen to individual stocks every day,and in shorter trends as well. When a stock is overextended—up or down—it willreverse. If the market is down seven days in a row, it’s probably oversold and youcan start looking for a return to the median. The longer a stock or index moves in
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one direction, the more pressure it builds to reverse direction, even if it’s only temporary. For a reversal to occur, some conditions must be present:• A trend must be in place before it can reverse.• The breaking of a major line of support or resistance is a strong indicator atrend has reversed.• A market top is usually shorter and more volatile than a bottom.• Volume dwindles at the bottom, and the trading range often narrows considerably.Reversal: The point at which a trend reverses direction, enabling savvy traderswho catch the reversal to get in early as the new trend takes off.
The funny thing is, every experienced trader expects a reversal, but many areslow to recognize it when one occurs. This is where the contrarian mind-set is useful, because so much sentiment (positive or negative) can build toward a stock orindex. It causes people to react slowly.Don’t try to call the top or bottom precisely. It’s better to look for technicalsigns that show that a reversal is possible, or that the trend will continue in thesame direction.
REVERSAL PATTERNSI want to start with reversal signals because that’s where a trend first begins; onedies, and another is born. The biggest profits go to those in at the beginning of atrend. One reason is because knowledgeable investors and experienced tradersknow enough to go against the prevailing opinion and utilize the contrarian approach to catch the turn. As the trend matures, the makeup of those buying (orshorting) the trend gradually shifts from the knowledgeable investor to the momentum player, and finally to the little guy, whose presence has become synonymouswith tops and bottoms (the little guy, like the crowd, is always wrong).It’s a good idea, if you suspect the market is nearing its top or bottom, to reviewthe sentiment indicators. They will offer danger signals before the market’s priceaction will. The following Sentiment Indicators Quick Checklist may come inhandy:• Check the psychological indicators in Investor’s Business Daily for reversalpatterns you’ll hear about.• Check the Volatility Index (VIX). When the VIX is low, it’s time to go! When it’shigh, it’s time to buy! (www.cboe.com).• Check the put/call ratio (www.cboe.com).• Check the A/D line (BigCharts at www.bigcharts.com).
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Compare the Sentiment Indicators to the AveragesUnless your timing is uncanny (coinciding with the exact moment you read this),the sentiment indicators will be somewhere between anguish and exultation, as willthe charts. Now look at the charts again, and try to answer these questions:• Did the stock or index recently finish a move up or down? (Did it breakthrough an old resistance or support level?)• If it went up, has it leveled off and begun going sideways?• If it went down, has it reached an old support level? (Draw a horizontal linethat connects two old highs that have now turned to support levels.)• How long was the move up or down? Remember to look at volume, as it helpsmeasure the intensity of the move.
Double Tops and BottomsThere are two reversal formations that many traders look for to confirm a bottom ortop: the double bottom (see Figure 12.1) and double top. Support at a new low willform before the stock reverses. The subsequent rally sometimes fades, indicating thebulls just couldn’t overcome the abundance of sellers. The stock or index either teststhe lows again or gets very close to it, and rallies a second time. If this cycle is repeateda third time, it’s of course called a triple bottom (see Figure 12.2). These are very bullish patterns. The wider (longer) they are, the stronger the ensuing rally. When this formation is applied to a topping out of an index or stock, it’s generally not as wide, andwill be more volatile. Use extreme caution if the second attempt does not exceed theprevious high. What has happened is a lower low, the very definition of a downtrend.Double bottom: A price pattern or market average that has declined two timesto the same approximate level, indicating the existence of a support level and apossibility that the downward trend has ended.Double top: A pattern that has advanced two times to reach the same resistancelevel. The first top must be followed by a breakthrough of the support level before climbing back up to the top again. After the second peak, the stock mostlikely falls back to the support level before continuing to trend or reversing.
Another good pattern to look for a reversal is called a rounding bottom. You cansee from the chart in Figure 12.3 why it gets that name—there’s a wide, curvedbase. This is a great pattern because it is wide, and as I’ve said before, the wider(longer) it is, the stronger the move up. It’s the timing of it that is frustrating, because this may take a very long time to form. Be patient.
Head and ShouldersA head and shoulders is a bearish price pattern that has three peaks resembling ahead and two shoulders (see Figures 12.4 and 12.5). The stock price moves up to its
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Figure 12.1
Double Bottom Formation (Courtesy of QCharts (www.qcharts.com))
Figure 12.2
Triple Bottom Formation (Courtesy of QCharts (www.qcharts.com))
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Figure 12.3
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Rounding Bottom Formation (Courtesy of QCharts (www.qcharts.com))
HEAD
LEFT SHOULDER
RIGHT SHOULDER
NECKLINE
HEAD AND SHOULDERSAS A REVERSAL PATTERN IN AN UPTREND(BEARISH)
Figure 12.4
Head and Shoulders Pattern in an Uptrend
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INVERTEDHEAD AND SHOULDERSAS A REVERSAL PATTERN IN A DOWNTREND(BULLISH)
NECKLINE
RIGHT SHOULDR
LEFT SHOULDER
HEAD
Figure 12.5
Inverted Head and Shoulders Pattern in a Downtrend
first peak (the left shoulder), drops back, then moves to a higher peak (the top of thehead), drops again but recovers to another, lower peak (the right shoulder). A headand shoulders top typically forms after a substantial rise and indicates a market reversal. A head and shoulders bottom (an inverted head and shoulders) indicates amarket advance.
CONTINUATION PATTERNSA sharp rise in price of a stock or index is followed by a resting period, called a consolidation period. You might say the market needs to catch its breath while the newprice level regains equilibrium. Typically price action narrows and the volumedrops off while investors and traders attempt to get a better sense of the next move,up or down. Visually, a consolidating market may resemble a triangle or a rectangle.Experienced traders watch for these consolidations carefully. But tread softly! A relatively short consolidation period should be viewed with caution since not enoughof a new base may be in place to support the next thrust up. However, a prolongedconsolidation is thought to be a good base for the next trend.Consolidations have different looks. One such formation is called a rectangle because it creates an oblong box. Figure 12.6 shows a daily chart of General Electric
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Figure 12.6
Consolidation Pattern (Courtesy of QCharts (www.qcharts.com))
(GE), a good example of how a stock will move, then rest. Although GE was fortunate enough to move up each time, you can see how important it is to watch supportand resistance levels. If you want to buy the stock, and you see it clear resistance,that’s the time to get in; or if you’re in and it breaks support, that’s the time to get out.In Figure 12.6, note that the two consolidation periods are both shaped like a rectangular box. Many traders will lock onto this range, buying at the support level andselling as it nears resistance. The obvious drawback to this strategy is selling beforethe breakout. Many other investors will wait for the breakout to occur before gettingin. Their buying begets more buyers, namely the momentum traders. If there is a largeshort position held by bears and they begin to cover, the stock can really take off.Once you see the stock has broken out of its recent trading range,exhibiting strong signs that a new trend has begun, be ready to act quickly.
TAKING ADVANTAGE OF RECTANGULAR CONSOLIDATIONSLong call strategies offer limited risk (the amount you paid for the option) with anunlimited upside potential. This is called a directional trade and works best if thestock moves up enough to affect an increase in the option contract. But a long callhas one drawback: Once a stock has broken out (or down), the premiums on the
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options become more expensive. Therefore, we can take advantage of the higherpremiums by going one step further, by putting on a vertical spread trade.Vertical spreads offer limited potential profits as well as limited risks by combininglong and short options with different strike prices and like expiration dates. The juxtaposition of long and short options results in a net debit or net credit. The net debit of a bullcall spread and a bear put spread correlates to the maximum amount of money that canbe lost on the trade—welcome to the world of limited risk. However, the net credit of abull put spread and a bear call spread is the maximum profit potential of the combinedposition—limited profit. Success in this kind of trading is a balancing act. You have tobalance out the risk/reward ratio with the difference between the strikes—the greater thestrike difference, the higher the risk, but also the higher the potential reward.One of the keys to understanding these vertical spreads comes from grasping theconcepts of intrinsic value and time value—variables that provide major contributionsto the fluctuating price of an option. Although changes in the underlying asset of anoption may be hard to forecast, there are a few constants that influence the values ofoptions premiums. The following constants provide the key to why vertical spreadsoffer a healthy alternative to traditional bullish and bearish stock trading techniques:• Time value continually evaporates as an option approaches expiration.• OTM and ATM options have no intrinsic value; they are all time value andtherefore lose more premium as expiration approaches than ITM options.• The premiums of ITM options have minimum values that change at a slowerpace than OTM and ATM options.• Vertical spreads take advantage of these differing rates of changes in the values of options premiums.The four vertical spreads that we use can be broken down into two kinds of categories: debit and credit spreads, each with a bullish or bearish bias. The success ofthese strategies depends on being able to use options to exploit an anticipated directional move in a stock. As usual, timing is everything. To get good at forecasting thenature of a directional trend, try monitoring option volatilities and keeping track ofsupport and resistance levels. Remember, a breakout beyond a stock’s trading rangecan happen in either direction at any time. Limiting your risk is a great way to levelthe playing field.Vertical spreads are excellent strategies for small investors who are gettingtheir feet wet for the first time. Low risk makes these strategies inviting.Although they combine a short and a long option, the combined margin isusually far less than what it would cost to trade the underlying instrumentand provides special advantages in the case of consolidating markets.
For example, in Figure 12.7 you can see how Seagate (SEG) broke out of its tradingrange but then fell back to support (see the old high from a week or two previous). Thestock pulled back to just below its 50 DMA, and stayed there for about a week beforemoving higher. Strong stocks on pullbacks are good candidates for spread trades,
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Figure 12.7
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Seagate Price Chart (Courtesy of QCharts (www.qcharts.com))
especially if you believe the market and the stock are going to rebound soon. (You canalso do the same kind of trade only with a downward bias if conditions warrant.)A bull call spread would have been an excellent way to take advantage of Seagate’smovement. A bull call spread is a debit spread created by purchasing a lower strike calland selling a higher strike call with the same expiration dates. The total investment isfar less than that required to purchase the stock. A bull call spread offers a limited profitpotential and limited downside risk. The maximum risk on one of these trades is equalto the net debit of the options. The breakeven is calculated by adding the net debit (divided by 100) to the long call strike price. To calculate the maximum profit, simplymultiply the difference in the strike prices of the two options by 100 and then subtractthe net debit. The maximum profit occurs when the underlying stock rises above thestrike price of the short call hopefully causing it to be assigned. You can then exercisethe long call, thereby purchasing the underlying stock at the lower strike price and delivering those shares to the option holder at the higher short price.Bull call spread: A strategy in which a trader buys a lower strike call and sells ahigher strike call to create a trade with limited profit and limited risk. A rise inthe price of the underlying increases the value of the spread. Net debit transaction: Maximum loss = debit; Maximum gain = difference between strike pricesless the net debit. No margin is required to place this kind of spread.
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Using Seagate, let’s say we created a bull call spread by purchasing 1 SEG January2002 50 Call and selling 1 SEG January 2002 80 Call for a debit spread of 9 or better.Risk on this trade is 9 points, while maximum reward is 21 points. Since it is always agood idea to confirm direction of the stock before entering a trade, the ideal time to putthis spread in place was after the bullish trend was confirmed. In this case, the stocksold off on Monday following an uptrend on a Friday. When the stock turned back upmidweek, and began to show strength, this was the perfect time to enter the spread.It’s a good idea to work out your strategy the night before, or sometimewhen the market’s not open, so you can coolly evaluate conditions andpricing. Then you’re ready to watch and wait for the best entry point.
Figure 12.8 shows the risk graph of this trade. It indicates the potential loss andprofit. On a spread trade, you sacrifice a little of the upside potential and really limitthe amount you could possibly lose. In this case, if the stock closes below $50 (horizontal axis) there is a total loss of capital. However, $59 is the approximatebreakeven point, and you profit whenever the stock goes above that price.Bull Call SpreadStrategy = Buy a lower strike call and sell a higher strike call with the sameexpiration dates.Market Opportunity = Look for a moderately bullish market where youanticipate a modest increase in the price of the underlying above the price ofthe short call option.Maximum Risk = Limited to the net debit paid for the spread.Maximum Profit = Limited [(difference in strike prices × value per point) – netdebit paid].Breakeven = Lower call strike price + net debit paid.Seagate Technology Inc.Theoretical Gross Out P&L3000
2000
1000
0
-1000$40
Figure 12.8
$50
$60
$70
$80
$90
Bull Call Spread Risk Graph (Courtesy of Optionetics.com)
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ANOTHER CONSOLIDATION PATTERN:NARROWING FORMATIONSA narrowing formation differs from a rectangle consolidation pattern because the support and resistance lines begin to converge toward a focal point somewhere a few daysor weeks out. During this period the stock or index will experience a drop in volumeand a narrowing of the trading range. This period of consolidation will test resistancelevels and support, forming what appears to be a three-sided figure. Essentially whatthe trader will look for is a triangle of some sort. It can have higher lows and an evenlevel of resistance (see Figure 12.9), or just the opposite, as shown in the Amazon.comchart in Figure 12.10. Think of this type of pattern as a spring coiling before it jumps—the longer the pattern, the bigger the move. To technicians, triangular consolidationscome in three forms: flags, pennants, and triangles. Ascending triangles are consideredbullish because of the series of higher lows and resistance remaining level. The pressure is building from the bottom, the interpretation being it will spring up. Descendingtriangles are considered bearish because of the series of lower highs and support remaining level. The pressure is building from the top, the interpretation being it willspring down. Bearish strategies work best for descending triangles; and bullish strategies work best for ascending triangles. Figures 12.9 and 12.10 show examples of ascending and descending triangular patterns, and their classic results.
Figure 12.9 Ascending Triangle—Check Point Software (CHKP) (Courtesy of QCharts(www.qcharts.com))
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Figure 12.10 Descendinig Triangle—Amazon.com (AMZN) (Courtesy of QCharts(www.qcharts.com))
The pennant is another type of triangular pattern to watch out for. When this typeof pattern begins forming, the likelihood of correctly determining the direction of thebreak is slim. Like other consolidation formations, the volume drops and the rangenarrows, only this time it’s with a higher low and a lower high. This quieting createsthe perfect setting for a straddle (the simultaneous purchase of a call and put, at thesame strike and for the same month). In this strategy, you don’t care which directionthe underlying stock moves in, just as long as it moves beyond the upside or downside breakevens. Figure 12.11 shows an example of a pennant formation.
Straddle: A nondirectional option strategy that combines the simultaneous purchase of the same number of puts and calls with the identical strike prices andexpirations. The maximum loss is limited to the net debit of the options. The upside breakeven is equal to the net debit (divided by 100) plus the ATM strikeprice and the downside breakeven is calculated by subtracting the net debit (divided by 100) from the ATM strike price. The maximum profit is unlimited inboth directions beyond the breakevens.
In this kind of formation, the volatility of the stock and hence the option premiums fall sharply. This is the beauty of the straddle. Extrinsic value drops considerably, so you’re not paying for a lot of time value. When the stock and options come
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Figure 12.11
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OEX Pennant Pattern (Courtesy of QCharts (www.qcharts.com))
alive again, you benefit from the move in the underlying stock as well as an increasein the extrinsic value (implied volatility) of the option!
PULLING THE TRIGGER: ORDER ENTRYPerhaps no other factor when investing or trading is as critical to a successful tradeas the order entry. Think about it. You could buy the most successful stock of alltime, but if you got in at the wrong time, the pain factor would probably take youout of the trade. If you buy too high, it’s going to be a long haul to break even. Themost destructive thing about a bad entry isn’t the resulting bad trade; it’s the subsequent agonizing over your mistake. Focusing on a bad trade makes you lose sight ofother more profitable opportunities, not to mention the psychological trauma of riding a loser back to break even so you can exit without incurring a loss. (Then it goesup and you’re on the sidelines.)Finding one trading strategy that works is the optimal approach. There is no needto learn firsthand every single option strategy known to man to be successful. Likelearning about sectors, you start with one strategy at a time, and practice gettinggood at it. This is important! Do one trade well, and eventually you’ll be successfulwith it. Fortunes are made doing this. It may not be sexy or glamorous or even
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exciting, but the object of all this work is to make money, not sound like a genius infront of your friends.Here’s a methodology I've used to find a system that works:First, I look for stocks that have recently made 52-week highs and that then pullback to some area of support but do not break below their 200-day moving average.I use an oscillator called stochastics to help me enter the trade. Stochastics is aleading indicator that records closing prices relative to a recent trading range over aspecified period of time (see Figure 12.12). The general idea behind stochastics isquite simple. A stock trending upward tends to close near its high of the day and astock trending downward tends to close near its low of the day. The indicator attempts to spot reversals in recent trends. For example, if a stock is in a primary uptrend, but is in the process of pulling back and its closing prices begin clusteringaround the highs of its daily trading range, there is a high probability that a rise inprice will follow. Conversely, in an upward-trending market, if a stock begins closing near its daily lows, the upward trend is likely to reverse. This indicator can helpto improve entry points and pinpoint when the primary trend is going to resume.To learn more about technical indicators and how to use them, go to:• Bridge News: www.bridge.com• Trading-Ideas.com: www.trading-ideas.com/guide/technical.html
Figure 12.12 Sun Microsystems (SUNW) Stochastics Example (Courtesy of QCharts(www.qcharts.com))
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USING SENTIMENT TO CONFIRM THE CHARTSIn the chart formations I’ve shown you, interpretation is required. We’ve had theluxury of seeing what happens over a time period, and determining what tradewould have worked. Not so in real life. This is where sentiment indicators can helpsharpen the picture. It won’t always help, but they certainly won’t hurt either.Sometimes you’ll call it correctly, and sometime you’ll miss. Such is life.What does a good trade idea look like? Technically the charts look good. Fundamentally, it’s a stock you’d like to own, and the sector is performing well (i.e., it’sgoing up overall or appears to be turning). The only item left can be easily overlooked: sentiment. It only takes a few extra minutes of preparation, but these minutes can be vital to your success. Here’s a quick checklist of sentiment indicators:• Put/Call Ratio: A lopsided ratio can indicate extreme bullish or bearishtraders. Contrary indicator. (E*Trade has a great feature for this, and it’s free atwww.etrade.com.• Short Interest: What’s the short position? This is stated in “days to cover.” Basically, the longer it takes to cover, the more pessimistic the sentiment; but ifyou’re a contrarian, the more bullish the sign. Check with Zacks (www.zacks.com) or Allstocks.com (www.allstocks.com).• MACD and/or RSI Oscillators: Check for overbought or oversold extremes.• On-Balance Volume: Is the stock trending more toward accumulation ordistribution?• Volume versus Price: Is volume trending with or diverging from the price? Increasing price and decreasing volume is not good.• Insider Buying/Selling: Always a telltale sign. Check out insiderSCORES.com (www.insiderscores.com/index.asp).
TERMINOLOGY REGARDING MARKET BEHAVIORCommentators or guests on financial programs discuss various terms that might beunclear to you as to their meanings, not to mention their implications. Listed nextare popular indicators of conditions, their meanings and significance.
Market BreadthEveryone hears about the Dow being up or down on any given day, but the marketbreadth data provides deeper insight into the general direction for the day, week, oryear. Here are listed the most commonly used market breadth indicators you’ll see.(These numbers are “per exchange.”)• Advances: Total number of issues gaining in price.• Declines: Total number of issues declining in price.• Unchanged: Total number of issues whose prices did not change.
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The advance/decline line compares the number of advancing issues (those increasing in price) against those that declined. Calculations are based on the opening trade ofnormal market hours as compared to the closing price. It doesn’t take into accountafter-hours trading. A strong A/D is a more in-depth indicator of the breadth or strengthof the market. A market whose main index (like the Dow Industrials) is up big on theday, but whose A/D line is negative, signals that the rally was selective—not a verybullish overall indicator. All it takes for the Dow to be up or down is a strong movement by a few of the Dow components. The overall market may be down for the day,but if Microsoft or IBM had a huge day, the Dow indicates a gain for the day.The same holds true for the Nasdaq Composite index. Big days in either directionfor the big-cap names like Cisco or Dell may distort what really occurred that day.• New Highs: Stocks making new 52-week highs.• New Lows: Stocks making 52-week lows.The number of new highs and lows is significant because in order for the market toadvance, a good number of stocks need to break out of their recent trading ranges intonew territory (see Chapter 9 on technical indicators). When a stock is making newhighs, it’s bullish because everyone is making money (except of course the short sellers), regardless of their purchase price. Investors hang onto their winners, so supplydries up, and if demand stays constant or increases, the stock or stocks will run further.The opposite is also true for the new lows. Although most people are underwater,there are groups that are not—those that are selling the stock short, and those thathave owed the stock for a very long time. By definition, the new lows are usually defined as 52-week lows. For those firms that have been around for a long time, the 52week low may not be anywhere near the all-time lows. For instance, Coca-Cola (KO)reached a 52-week low in March 2000 when it dropped to almost $42 per share. However, that was not the all-time low—$42 per share was the all-time high back inMarch 1996, and thus anyone who had purchased it prior to March 1996 would stillbe in a profitable position. For all practical purposes, though, most KO stockholderswere underwater, or those with a really low basis fell underwater as they looked backon the $40 drop their stock had taken over the previous 18 months. In many cases,you can expect more selling if it stays down as investors cut their losses.• Advancing volume: The combined volume of all advancing stocks.• Declining volume: The combined volume of all declining stocks.• Total volume: Trading volume all stocks traded.
VolumeA/D volume and total volume are good indicators of strength. If the market is up big,but volume is poor, the rally’s credibility is uncertain; that is, it doesn’t do much to inspire further buying, as investors are sitting on the sidelines to get a better idea of market direction. Large volume days are better indicators of market psychology; if it’sdown or up on big volume, that’s your cue as to sentiment and the trend.
