In the “good old days” an investor could simply pump money into an “aggressive growth” fund or maybe an S&P 500 index fund and just wait for the profits to accumulate.
Nowadays that strategy seems so “a couple of decades ago.” As you can see in Figure 1, had an investor finally succumbed to all of the talk of “a new paradigm” (remember that one?) and bought shares of the S&P 500 tracking ETF ticker SPY on July 16th, 1999 – or to put it in starker terms, 13 years(!) and about a month and a half ago – he or she would be just about breakeven as of today.
Figure 1 – SPY Unchanged 13 years later
So let’s see, 13 years plus, 0% return. Hmmmm. Not exactly the kind of return most of us are looking for.
So by and large, investors have had to “adapt” in recent years. Now the nature of said adaptation may vary quite a bit from individual to individual. But by and large, in a nutshell, it has meant having to do something besides just buying and holding – at least if you wanted to actually make some money.
It’s Time for a Football Analogy
With the football season kicking off (har, good one), it seems like a good time for a football analogy. In football – at least back in the day when defensive players were actually allowed to touch wide receivers and quarterbacks, when football was still more of a running game, when players would hit one another without trying to purposely injure one another and when players could actually celebrate scoring a touchdown – there was a phrase coaches used often that simply stated, “take what the defense gives you.”
So we will adapt that phrase to read “take what the market gives you. In fact, to be slightly more accurate, because we are going to be looking to take advantage of short-term declines in individual securities, we will change our mantra to “take what the market gives back.”
What Goes on “Under the Radar”
Lots of investors look at price charts in an effort to discern “trends” and to attempt to identify “points when the trend seems likely to reverse.” And certainly charts can be useful. At the same time, many investors also look at certain indicators for subtle clues to possible reversals or extensions of trends.
One of the most popular – and often most subjective – tools for any technical trader is when price “divergences” from a given indicator. In other words, when price makes a new high (or low) and the indicator in question fails to confirm by also making a new high (or low), this can “sometimes” signal an impending reversal. Of course, a single divergence for a single day is not much to go on, so it makes sense to combine a handful of indicators.
Figure 2 displays the Technology Spyder ETF ticker XLK with two indicators plotted below the price chart. The top clip is the popular MACD indicator using settings of 18/37/9 (the standard default is 12/26/9).
Figure 2 – Ticker XLK with MACD and Rate-of-Change Indicators
The bottom clip is the 28-day Rate-of-Change indicator (today’s close divided by the close 28 days ago, thus a reading of 1.00 means price is unchanged) with a 28-day moving average of the daily readings.
In theory, these indicators suggest a bullish trend for the underlying security when they are in an uptrend (for MACD a green up arrow is favorable and a red down arrow is unfavorable; for ROC when the red line is above the blue line the trend is favorable and vice versa). Also in theory, the price trend should be that much more bullish if both indicators are favorable and the price trend should be that much more bearish if both indicators are unfavorable.
So now we have a relatively crude, yet relatively simple way to identify the trend “beneath the surface”, now let’s add one more indicator as a trigger.
Adding a Trigger
We now add the 3-day RSI indicator. What we are looking for is one of the following two setups:
-MACD and ROC both favorable AND 3-day RSI drops below 30 and then turns up for one day (as a buy signal).
-MACD and ROC both unfavorable AND 3-day RSI rises above 70 and then turns down for one day (as a sell short signal).
-If we get a buy signal we can either buy the underlying security or an at-the-money call option. We would sell when the 3-day RSI reaches 70 or higher.
-If we get a sell short signal we can either sell short shares of the underlying security or buy an at-the-money put option. We would cover our short position (or sell the put option) when the 3-day RSI reaches 30 or lower.
One Bearish Example
Figure 3 displays a bearish setup for XLK on 4/27/2012. Despite the fact that price jumped sharply over a three day period, both the MACD and Rate-of-Change indicators remained bearish. Likewise, the 3-day RSI popped up above 70 and then turned down at the close on 4/27.
One could have sold short shares of XLK at the next open at $29.99 or bought the June 30 put for $75 per contract. Five trading days later, the 3-day RSI dropped below 30 and XLK shares could have been bought back at $29.43 and the June 30 put could have been sold for about $1.00 a contract. So an option trader who bought 10 contracts for $750, could have sold them for $1,000 and a 33% profit.
Figure 3 – XLK Bearish Setup (4/27/12) and downside break
As always, traders should be reminded that there is nothing magic about the setup I’ve detailed here and there is certainly no guarantee that any particular signal will generate a profit. Still, the real point is simply to highlight the facts that:
a)There are a lot of ways to play this game (which is especially important to note given that buy-and-hold has returned essentially 0% over the past 13 years).
b) There are momentum shifts that go on “beneath the surface” of the price action that we can observe on a price chart. These shifts can provide important clues to alert invetors.
Given a) above, learning more about b) sounds like a pretty useful idea.
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site