It’s been a hectic two weeks since I last left off. The market is still in limbo as investors are still trying to figure out the general direction. The economy still seems strong.
Stock Market For Beginners:
Before I dive into this article, I would like to let you all know that I just finished my Product Management internship at Google and will be going on vacation to Peru in the following week, so I won’t be posting until I get back.
In last week’s stock market overview, I examined the correlation between the S&P 500, the Volatility Index, and the Put/Call Ratio. These indicators showed that the market was likely to rebound soon, but I indicated at the end of the article that a bottom may not have yet happened.
It seems, now, that we may have found that bottom.
While the technicals look good, remember that in a volatile market like this, it’s crucial to follow proper risk management techniques.
Honeywell (HON) is an aerospace and defense products and services company that is one of the thirty stocks that comprise of the Dow Jones Industrial Average. They primarily make money by selling its products and services to the government through space and military technology.
The volatility has continued to keep this market on its toes as investors continue to struggle to find direction. The underlying economy still appears sound, but credit concerns have continued to plague the market.
In the following three charts, I’ve annotated the S&P 500, the Volatility Index, and the Put/Call Ratio. You’ll find that the blue arrows all correspond to lows in the S&P. Furthermore, you’ll see that every time the S&P 500 has dipped to the 50 RSI level, the market has had a corresponding low as well.
In my previous article on volatility, I covered the basics of how high volatility measures the amount of fear present in the market and how that often corresponds with a market low. Take a look at the chart to find that when the volatility hits a local high that the market hits a local low.
The put/call ratio measures the number of puts (options that are essentially short the market) divided by the number of calls (options that are essentially long the market) to gauge market sentiment. Historically, it has been found that high put/call ratios correspond to market bottoms and that low put/call ratios correspond to market tops. Again, take a look at the chart to find that when the put/call ratio hits a local high that the market hits a local low.
While we may not have yet hit the bottom of this correction, it is very likely that we will soon be heading back up based on previous indicators.
The elimination of the short-sell “up-tick” rule has made a sketchy market even scarier. The Securities Exchange Act of 1934 was created to provide governance of securities transactions on the secondary market and to regulate the exchanges and broker-dealers in order to protect the investing public. Within this law was a rule that required short-sellers to wait for an up-tick in a stock before they could short. An up-tick can be defined as a trade price that is higher than the immediate preceding trade price. This was created to prevent manipulation, avoid large and steep declines in stock prices, and help create an orderly and balanced marketplace.
On June 13th, 2007, the rule was repealed after some small sampling showed that there was not an increase in volatility when the rule was not in effect. But now that short sellers can hit bids to short, I cannot see how that does not cause more volatility. Before the repeal, only investors that were already long could hit bids. Now, these same investors must compete with short-sellers to get out of a stock which will automatically make stocks drop harder and faster than they normally would because the specialists that provide the markets cannot get out of the way fast enough. This will make the price become oversold to a point where value investors step in and cause the stock to whip back up. The whip back up will be exaggerated due to the fact that short-sellers now need to cover and buy at any price. The specialist and market makers have a new dynamic to contend with now after the rule change. Before, they could see short sellers in their book waiting for up-ticks to be executed. Now, short-sellers do not have to put offers out there that are higher than the trading stock price. Instead, they can just come in and hit the specialist and market makers bids, forcing specialist and market makers to move their markets faster. Also, specialists protect themselves by making wider and thinner markets to avoid over-commitment.
Remember, specialists make money by buying on the bid and selling on the offer. The more they do that, the more money they make. It is their job to find a fair value where both buyers and sellers match up and they can buy on the bid and sell on the offer all day long. They don’t make money when they are just on one side just buying or just selling. If they are just buying, they move the stock down until some other buyers appear and if they are just selling they move the stock price up until they find some sellers. Now, with short-sellers being able to hit bids, specialists are being overwhelmed and must move stocks down much faster and deeper causing increased volatility.
It is going to take some time for specialists, market makers and the trading public to become use to this new phenomenon. What that means for us is that volatility is here to stay and if you want to make money in this environment, you need to adapt.
The Federal Open Market Committee (FOMC) meeting today will be the most influential event of the month. With all the bad news that keeps piling up about the credit issues arising from loose lending in the past two years, this market needs to know that the Federal Reserve Bank is there to provide liquidity by saying that it is no longer biased towards tightening interest rates. This statement change is needed and expected by the market. In the absence of this statement, the market will more than likely resume its sell-off.
Whatever the Federal Reserve statement may be, wait for Wednesday’s trading results to give you an idea of how we will trade for the rest of August. The last two hours of trading after the Tuesday, August 7th 2:15 PM EST announcement will be very volatile but is usually a knee jerk reaction. After spending a night digesting the news, the real players will come in on Wednesday to commit to real positions. Watch high yield ETFs like HYG and brokers like Bear Stearns (BSC) and Goldman Sachs (GS) to give you leading indications. Look to see how we close. If we continue to sell-off Wednesday, the rest of August may be spent trying to find a bottom. If we end positive on Wednesday, we may have a temporary market bottom in place with a potential for a follow through in the coming weeks.
Because of the uneasiness investors feel about unknown losses in the corporate high yield debt markets and deepening slowness in the real estate market, the likelihood of a 500 point drop in the Dow Jones Industrials is very possible a day after the Fed makes their decision. On the other hand, because of the huge amount of short interest, growing amount of cash on the sidelines, and technically oversold conditions, the Dow Jones Industrials may very well rally 500 points the day after the Fed’s decision.
What the Fed will say and which way the market will react is very hard to predict. The only sure thing will be huge volatility following the announcement. Look for sentiment on Wednesday, August 8th to be your guide.
The stock market is fascinating because you can make the right decisions and lose money or make the wrong decisions and make money. Far too often, experienced investors get caught up in the day to day performance of their portfolio that they lose sight of the big picture of making long term profits. Here’s a very applicable quote from Edwin Lefevre in Reminiscences of a Stock Operator:
My plan of trading was sound enough and won oftener than it lost. If I had stuck to it I’d have been right perhaps as often as seven out of ten times. In fact, I always made money when I was sure I was right before I began. What beat me was not having brains enough to stick to my own game - that is, to play the market only when I was satisfied that precedents favored my play. There is a time for all things, but I didn’t know it. And that is precisely what beats so many men in Wall Street who are very far from being in the main sucker class. There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time.
The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages.
Lefevre’s lesson rings true with my poker experience as well. I knew that I was a long term winner at the game, but far too many times, I would play hands that were negative expected value because for some reason I was bored and wanted action. In these times, I let emotion take over and the desire to win the current hand regardless of the theoretical correct play. Obviously, it’s difficult to realize when this deviation occurs until after the fact, and even more difficult to discover if you don’t keep some sort of performance journal (that’s why so many pros will keep poker or trading journals).
The same idea goes for investing. You can have the best trading strategy in the world, but if you don’t stick to the game plan, it’s worthless. I want to do a little thought exercise to see how we can conquer this obsession with the present and winning in the now.
Imagine that you created a trading or poker machine that always made good money in the long run. If you let it run over the course of a year unobserved, you’d be guaranteed a pretty substantial return. Now, let’s say that you could watch the robot’s performance on a daily basis. You would find that there would be great fluctuations in it’s daily performance: some days the machine would win big and some days the machine would lose big. If you were to watch the machine lose a large amount on one day, would it be wise to tell it to change its strategy? Obviously not. In fact, the only reason you might be tempted to tell it to change its strategy is because you became emotionally involved in the short term fluctuations. The best thing to do is to let the machine continue with its current strategy and it’ll continue to offer you solid returns.
Hopefully you can see how this analogy can be applied to your trading philosophy. If you have a solid investing plan, you need to trade like a machine. Pull away from the emotional urge to win on a day to day basis and look at the big picture.
There is, however, one caveat to this concept. It assumes that you have a solid trading plan that has a positive theoretical long term expected return. If your strategy is not profitable, then sticking to your plan through downswings can make you go bankrupt. That’s why it’s crucial to keep a trading journal to monitor your performance. I will go into more depth on the importance of keeping a trading journal later on.
I’m proud to say that I’ve officially been blogging on The Fresh Trader for two months now. I started The Fresh Trader in the beginning of June in order to promote stock market for beginners. I’ve received a lot of positive feedback, adhered for the most part to my goal to make at least one post per day, and learned more about the stock market in the process.
Thank you for taking part in my investing journey, and if you’ve found this site as enjoyable as I have, I hope you can share it with all of your friends! Here are some of The Fresh Trader’s most popular posts for the month of July.
Insider Buying (Part 1) (Part 2) (Part 3)
Insiders have knowledge about their company that nobody else has. In this three part series, I show you how to profit off insider activity.
Investor Psychology: Falling in Love with Our Stocks
Renowned Harvard psychologist Daniel Gilbert explains why investors fall in love with their stocks.
Volatility Index and the Stock Market
Today’s market permeates with volatility. Find out how you can apply volatility indicators to your trading arsenal.
Understanding this crucial concept will be the first step toward successfully managing your risk, which is crucial in today’s volatile markets.
Losing money does not equate to a losing trading strategy and system. Find out how variance affects your performance and how you should view the market behind the lenses of luck.
Subprime Crisis Affects the Stock Market
I’m sure you’ve heard of the subprime crisis and its devastating effects on the market. Find out how you can profit by keeping an eye on the debt market.
If you want to truly become a great trader, check out these must-read investment classics.
The stock market has continued to be extremely volatile and the bears have taken control in the last two weeks. You can see the vast difference in volatility by comparing single-day movements between the run up from April to June and the wild fluctuations from June to August.
In general, I would be very cautious about entering the market right now. Technically speaking, there’s still a long ways to go before we find support. Fundamentally, the market still looks good, but it seems as if people are overreacting. Look to buy when the market shows improving strength and confirmation. Remember that in today’s volatile markets, it’s essential to practice solid risk management strategies.
<< Previous Stock Market Overview - July 29th <<
I’m sure you’ve heard the terms “long” and “short” thrown around in investing jargon. Many of you may have always wondered what that meant. Well, going long on a stock means that you are purchasing the stock expecting it to go up whereupon you can sell the stock for a profit. This is the traditional form of investing that most people are used to. Going short on a stock means that you are borrowing and selling the stock expecting it to go down whereupon you can buy the stock back and return it for a profit. In essence, going short on a stock is the same thing as going long, except you’re doing it in the opposite order.
Let’s take an example to illustrate this point. Let’s say that you think stock XYZ is going to fall in price for some reason, so you decide to short 5 shares of XYZ at $10 each. Here are the steps involved in initiating a short position:
You now have $50 in your pocket and owe 5 shares of XYZ.
Now let’s say that a week later, XYZ has indeed fallen to say $5. Here are the steps to cover (or buy back the stock to neutralize your short position) your position on XYZ:
You now have closed your position and have come out with a profit of $50 - $25 = $25.
Further Reading