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Whales on the beach

I dunno why, but I have this mental picture of the stock market as a kind of ocean ecosystem. The smallest retail investors are sort of like plankton or tiny krill. They can see what's happening around them and sometimes get ahead but unless they're very smart and very nimble they get swallowed up by larger fish. Most of them get eaten before they even know what or how it happened.

Next up are the various sizes of fish. Hedge funds are the barracuda and trigger-fish. Retirement funds are big old stately tunas. Mutual funds are like jelly fish floating with the currents, their stinging tentacles dangling beneath them.

At the very top of the food chain are the largest investment banks and sovereign wealth funds. These huge entities correspond to the blue whales, gliding slowly through the ocean eating up all the smaller creatures. They're seemingly impervious to the daily gyrations. Most of us small investors don't even see them they're so huge. To us they're just big, shadowy profiles moving slowly through the depths.

When we see days like the past week where the market swings wildly between down huge and up huge it's like watching a gigantic whale jerk and convulse and, finally, choke up a mountain of bloody stinking stocks and ultimately go silent. Scavengers swarm around the corpse. Eventually the waves push the carcass up onto the beach where men from the government cover it with blue TARPs.

Only after the fact do we learn the whale's names: Bear Sterns, Lehman Brothers, or maybe Citi Group.

Hmmm. Maybe I stretched the analogy too far.

Why so serious?

We have got to be nearing some sort of meaningful bottom to this mess because the media is treating us to an especially large dose of the sad face this morning:

CNN:

MSNBC has a whole slideshow of the sad face for your viewing pleasure:

And CBS and ABC can't be left out of the glumness:

It's interesting to note that neither of the two "serious" financial news sites that I follow (Bloomberg and MarketWatch) have any sad faces up at all.

After hours margin call

Here's what an after hours margin call looks like:

Some poor schmuck (not me!) was forced to sell his/her 800 shares in the thinly traded after hours market. Yikes! Just another reason to not play with margin!

It's funny how 800 shares, just 0.5% of the day's volume in this stock, could swing the price so widely. Of course, tomorrow is a different day and the dude dumping his shares tonight for a 3.2% haircut could suddenly look like a genius.

More Evidence A Recession Is Coming

I just saw this on arstechnica.com:

Last week, we found out that Apple had decreased its iPod and iPhone orders, a move which analysts suggested was due to an expectation of lower demand for those products in the coming months. Many people thought that the recent production cuts were it, but it appears Apple is bracing itself for an even worse spring.

As computers go, Apple's products are high quality, stylish, and well designed. But you do tend to pay more for that quality and I'd put them squarely in the Consumer Discretionary category. If you have money to burn you get a Mac; if you don't you go for a low-end Dell PC or assemble a clone box yourself.

When you start hearing about Apple slashing production you know something's up with the consumer. Their stock price reflects this:

That's one sick looking chart!

Edit: Charts like the one above are why you never ever never hold onto a losing stock, no matter how great a company you think it is. If a stock shows you a loss then you sell it immediately. Take your loss and live to trade another day.

2007 Sector Performance and the Business Cycle

Happy New Year, everyone!

One of the main points John Murphy drives home in his excellent book Intermarket Analysis is that the business cycle drives sector rotation and that savvy investors can use this knowledge to position themselves correctly during the different phases of the cycle. The hard part is identifying which stage of the business cycle we're in so you can avoid buying stocks in the wrong sectors.

Here's a quick summary of the business cycle and the stock sectors that tend to do well during each stage:

• Early Expansion: Technology, Transportation
  
• Middle Expansion: Capital Goods, Basic Materials
• Late Expansion: Energy, Consumer Staples
• Early Contraction: Utilities
• Late Contraction: Financials, Consumer Cyclicals

And here's a really crappy picture I captured from Murphy's book using my MacBook's iSight camera that illustrates the concept a little better than the simple list above:

If you look at the relative performance of the various sectors during 2007 you can pretty much pinpoint where we are in the cycle (click for full-size version):

Relative to the S&P 500, the 2007 four top performing sectors are Energy (+40%), Materials (+19%), Utilities (+13%), and Tech (+9%). While not in the top four, Consumer Staples is gaining fast, having spent most of 2007 underperforming the market. This is interesting because Consumer Staples is considered a defensive sector and tends to gain during the early stages of an economic contraction.

If this trend continues into 2008 then it's very likely that we're currently transitioning from the Late Expansion stage of the cycle into Early Contraction. That would mean that Materials and Energy may be about played out and it's getting to be time to shift our attention towards the Utilities and Consumer Staples sectors. A recovery in the Financials is probably quite some time off and attempts to bottom-fish now could lead to significant losses or, in the very least, tying up your capital for a long time.

Oil vs. Airlines Inverse Relationship

Here's a chart of Crude Oil prices ($WTIC) versus the AMEX Airlines Index ($XAL) that I found while playing with Stockcharts.com's Perf Charts java applet:

Basically, this is telling us that the higher oil prices go the worse the airline stocks do. Except for the times when the market was freaking out (February and August of this year) the two charts are almost mirror images of one another. Even the percentage changes are very close.

If you think about it this relationship makes sense. Airlines are very sensitive to fuel prices because their ultra-competitive business environment limits their ability to pass higher costs on to their customers. I'd imagine any industry that is heavily dependent on the use of some limited physical commodity would have this sort of inverse relationship with that commodity.

I poked around and tried to find more commodity/Industry inverse relationships but Oil/Airlines was the most striking.

Another Leg Down In The Market Coming Soon?

I've been watching the market very closely these days and even though I'd like to think the worst of this mortgage mess is behind us, the tea leaves I'm reading here are flashing another "sell" signal. Working from the daily chart of the S&P 500 above, here's what I'm seeing:

• A descending broadening wedge formation appears to have begun building during the past two months. The yellow trend lines drawn along the peaks and troughs of the recent price action are clearly declining and opening up. This is a symptom of the extreme volatility we've been riding through. If the trend lines hold we stand to see a lot more wild action in the days and weeks to come.
• The recent advance has been accompanied by a decline in volume, which is almost never a good sign. A classic price/volume divergence before your very eyes.
• RSI(14) has reached 50, about the same area where the last wave peaked.
• Stochastics have reached oversold levels and appear to be ready to turn down again.
• A price/Stochastics divergence appears to be forming as well.

None of this technical analysis fortune-telling is 100% guaranteed but there are just too many bearish signals coming together for me to think we've seen the last of the bears. In fact, I'm pretty sure we haven't.

Just so I don't close this post on too bearish a note, here's a bear cub for ya'll to look at:

Ain't he cute? See, bears aren't so bad!

iFlash Comes in Handy for Learning Candle Patterns

A few weeks back I picked up a copy of Steve Nison's Japanese Candlestick Charting Techniques from Amazon so I could learn more about candle patterns. Nison's book is the "bible" of candle charting and is well worth the high price-tag. I'm only part way through it and what I've learned is already changing the way I look at charts. But I digress.

What I really want to talk about in this post is Loopware's iFlash application. iFlash is a deceptively simple flashcard study application that helps you to memorize stuff. You remember flashcards, right? I always hated using flashcards because, let's face it, they're boring! You sit there flipping through the 3x5 cards and there's no context or feedback so it's a painful experience. Using flashcards sucks.

So, anyway, memorizing candlestick patterns can be difficult because there are a lot of them and they all kind of look the same at first. Here are some examples for the uninitiated:

Because the "cards" in iFlash can accept images it's possible to use the candlestick patterns as the front of the card and the pattern name and interpretation on the back. Once you've got your "deck" setup you can flip through it quickly using the arrow keys. When you feel like you've learned a pattern well enough you can toggle it's "learned" flag and iFlash won't show it to you anymore. It's still rote memorization but because it's so easy to flip through the cards it's about as fun as these sort of tasks can ever be.

Loopware has a huge library of user-generated card decks covering practically any topic you can think of. Last time I looked there were over 1700 of them. Of course there weren't any candle charting decks available. Here's my little deck of 26 candle patterns that I've been slowly building. As I work further into Nison's book I'll probably add more cards to it. When I feel it's ready I'll upload it to the Loopware collection.

How to Fail As a Trader in 10 Easy Steps

Trader's Narrative has a great list of ways to fail as a trader:

1. Start out undercapitalized
2. Ignore risk management
3. Compare yourself to other traders, not yourself
4. Look for the right system
5. Don't keep a journal
6. Be secretive
7. Be casual
8. Fill your charts with as many indicators as possible
9. Trade with your emotions
10. Be inconsistent

You could call these the ten deadly sins of trading. There aren't many traders out there who can honestly say that they haven't fallen victim to at least one of these. I have personally been guilty of 1, 7, 9, and 10. #9 has been my personal nemesis but I'm working on that. If it hadn't been for my insane adherence to risk management I would've lost my shirt many times over by now.

You definitely should read the original post as each point is explained in more detail. It's good stuff to be sure.

Position Sizing

One of the most important questions you need to answer when opening a new trade is how many shares you should buy. Getting your position size correct is one way to reduce risk and increase your odds of having a winning trade.

There are several different ways to size positions but I think the best way is to let the stock itself determine it for you. That way you're not imposing some artificial limit on your trade that the market will not respect. In his book The Art of the Trade R.E. McMaster calls this "backing into the trade."

Say you have a $50,000 futures trading account and decide, in accordance with money management Rule 3 above, that you’re going to risk up to 5 percent of your capital, $2500, on any one trade. This means you have to be wrong 20 times in a row to be wiped out by the market. So far, what’s going on in the market has nothing at all to do with how you’re trading. You determine the number of contracts you trade by computing the dollar risk on each trade from entry point (the price at which you are willing to buy) to protective stop loss (the price at which you decide you will sell), and then divide that dollar amount into $2500. The result gives you the number of contracts you will trade. This way you equalize every trade.

In his example he refers to futures contracts but you can just as easily use the same method for trading stocks. By sizing your trade based off the dollar risk ($2500 in McMaster's example) then you're trading with the charts and not some inflexible rule that ignores the price action. Figuring the actual position size is simple algebra:

Shares = Risk / (Price - Stop)

This is for a long position. A short position is much the same:

Shares = Risk / (Sell - Cover)

Pretty easy and you should be able to tap that out on a pocket calculator pretty easily. However, if you're lazy then I have a simple position sizing web page that you can use.

Here's an example using a Microsoft chart:

In the MSFT chart you can see that the Purchase price will be $28.67 and that the stop point is down below the late March consolidation at $27.45. This is a spread of $1.22. If you divide that into the amount of risk you're willing to take on ($2500), then you get 2,050 shares:

2,050 = 2,500 / ($28.67 - $27.45)

Wait a minute, though. If you multiply 2,050 by the purchase price of $28.67 you get $58,773. That's more than we have in our trading account. You could always buy the extra shares on margin but that would mean that you've just poured your entire account into one trade and we know what they say about putting all your eggs in one basket...

If you have this problem there are two things you can do. The first is to move your stop price down to increase the spread between the purchase and stop. In the MSFT example this would mean lowering the stop to around $24.40. In my opinion this is a bad idea because if the price action were to actually go that low then it would mean your original trade premise was wrong and you should've been out of the stock long before your stop was hit.

The second method to solve the too large position problem is to modify the position sizing formula to 

 

Shares = Equity / Price

to limit the number of shares purchased to whatever money you have on hand. This is better than lowering your stops because you can still keep your stop where it should be but you're risking less money. Of course, if the position size goes low enough then it may not be worth it to actually enter the trade. There is such a thing as putting on too small of a trade.

Do we always need to use support or resistance levels for determining our stop points in order for this to work? Of course not. You can use whatever works for you or makes sense. In addition to chart-based support and resistance I often use pivot points, fibonacci retracements, and trend lines. The important thing is to place your stop where if the price action trades through it you will be convinced that your original trade premise was wrong and then sizing your position accordingly.