Archive for March, 2008

Contra-band: The Longs and Shorts of Contra-ETFs

Monday, March 10th, 2008

On Friday I mentioned Contra ETFs as a way for conservative investors to hedge their portfolios in falling markets. For all of you novice investors, an ETF is an acronym for Exchange Traded Fund. Think of it as a mutual fund that trades like a stock, which is exactly what it is. The beauty of ETFs compared with mutual funds is that getting in and out of them is a lot easier since you don’t have to wait until the end of the day to open or close your positions. The Spiders (SPY) and the Q’s (QQQQ) are examples of ETFs that are activley traded and widely held. With that said, let’s look at contra ETFs in more detail and discuss the best way to use them.

What is a Contra ETF?
A contra ETF is just what the name implies: It’s an ETF that uses instruments that inversely mirror the movement in its underlying index or sector. There are two types of contra ETFs–short and ultra short. A short fund tries to exactly mirror the inverse movement of its underlying instrument while an ultra short fund mirrors twice the movement of its underlying. As an example, let’s compare the SH (Short S&P 500) with the SDS, its ultra short counterpart. Since last October 11th’s market high, the SH gained 21% while the SDS doubled that to 43%. Sounds great, eh? It is great when the market is going in your favor, but if it starts to go against you, the downside to the ultra short fund is magnified.
Contra ETF Characteristics
All ETFs trade on the AMEX (the American Stock Exchange). Some are optionable, some are a lot more liquid than others, and most of them pay dividends. The majority of contra funds are offered by a company called Proshares. (For a complete list of their products, please visit their website: Rydex has a few, too. Here’s a list of the most active contra funds (those trading more than 150,000 shares/day) in order of decreasing volume along with their dividend yields:
[Note: All of the above ETFs are optionable except for the bottom three (PSQ, EFU, and SDD).]
How to Play the Contras
These funds can be used either for portfolio hedging or for speculation. If you’re using them as a hedge against portolio risk, you would use them the same as for any hedging techniques. (See my recipes on portfolio hedging.) You would buy them at market tops or when the market is just starting to turn around. How much do you need to buy? That’s entirely up to you, but if you want to maintain a market neutral position, you would need to buy a dollar amount equal to half of your long position in the ultra short ETF. For example, if you have $100,000 to invest, you would need to buy $33,000 in an ultra short ETF that mirrors your portfolio (say the S&P 500) and keep $67,000 in your long stock positions. If the market drops 10%, you would lose $6700 in the value of your stocks, but your SDS position (the UltraShort S&P) would increase by $6600, not including the dividend that it pays. You should also note that if the market keeps on dropping, you’ll need to sell some of your SDS shares to maintain your neutral position to avoid being overweighted on the short side. The risk to this strategy is if the market goes up, you’ll start losing money faster.
The other way to play these is for speculation. You think the market is going down and you want to profit from it, but you don’t like the concept of shorting, you don’t understand how to play put options, or you’re trading in a non-marginable account (like some IRAs). Here you would just buy the ETF you liked the best and set your stop/loss point just above the value of the underlying’s major resistance. For example, if you bought an S&P contra ETF today, your stop/loss point would be when the S&P crosses its 1300 resistance level.
Which of these funds do I like the best? I have to say that the chart of the QID, the UltraShort Qs, is the most compelling. It’s been range-bound since the middle of January and just broke out today. I would ride this down at least until the OEX (S&P 100) tests its 565-570 resistance level. It’s interesting to note that the contra ETFs in the energy and basic materials sectors (DUG and SMN) are showing signs of life. Perhaps these sectors that have been so stellar recently are starting to run out of gas? (Pun intended) If you’re overweighted in these areas, now may be the time to put on a little protection and purchase these contra ETFs.

Blog Round-Up Day

Friday, March 7th, 2008

If anyone out there remembers the original Mickey Mouse Club (the one with Annette in it), you might recall that every day of the week had a different theme. Monday was “Fun with Music Day” (my least favorite), Tuesday was “Guest Star Day”, Wednesday was “Anything Can Happen Day” (my fave), Thursday was “Circus Day”, and Friday was “Talent Round-Up Day.” Following that theme, I thought we’d do a follow-up on several of my previous blogs, namely the earnings news strategy, the royalty trusts, and the retailers.

But before we begin, I want to comment briefly on the current market ugliness. If you still don’t think we’re in a recession, the fact that all of the major indices just broke major support should confirm it. Even the all-important Dow Transport Index, a leading indicator of over-all market direction, broke down. The volatility index (VIX) gapped up continuing it’s pattern of higher lows. What’s a worried investor to do? If you still have long positions, lighten up your holdings and tighten up your stops ’cause we’re in for a bumpy ride at least until the indices test the next resistance level (1235 on the S&P). If you’re squeamish about shorting stocks, at least find out about contra-ETFs. They offer downside protection without having to open up a margin account. [Note to self: Do a blog on contra-ETFs.]

Royalty Trust Update (see Feb. 19 blog)
Wow, have these guys been performing! My favorite pick at the time, Permian Basin (PBT), has been the clear winner, up 19%. My second fave, BP Prudhoe (BPT), is up 11%. Jim Cramer picked up on these stocks on March 5th. He likes the ones I mentioned along with Hugoton (HGT) which has also been an advancing juggernaut. Of the others I mentioned, SBR and CRT are threatening to break overhead resistance as we speak. Williams Coal (WTU), the dog of the group back then, is now turning into a leader and is threatening to break-out. (Who knew?) As long as oil and energy do well, so will these. Remember too that the beauty of these trusts are that they pay generous dividends (8-13% dividend yield) and make great assets to any tax-sheltered accounts. (Disclaimer: One of my funds owns PBT.)

Retail Stocks (see Feb. 13 blog)
Higher consumer prices and lower consumer confidence has shoppers shying away from apparel and moving into the lower-end retailers. Although Wal-Mart just announced a dividend increase and reaffirmed guidance, the stock remains range-bound. Today, it’s looking like it might be heading lower along with the other best-of-breeds, Urban Outfitters, Buckle, Aeropostale, and Gymboree. I can’t find one chart in this group that looks compelling. The best course of action is to wait until the economy shows signs of turning around before jumping in.

Earnings News Portfolios (see Feb. 28 blog)
Last week I outlined a strategy for playing companies just after their earnings are released. I created two mock portfolios each consisting of five stocks; the long portfolio was made up of companies that blew away their earnings estimates, and the other was a short portfolio of those whose earnings came in worse than expected. Since these were short-term plays, I closed out both portfolios yesterday for a total return of -2% on the longs and +22% on the shorts. (I have my portfolio manager set-up to sell when a stock hits a 10% loss, so that I sold HURC and CTRP in the long portfolio a few days ago.)

Does this mean that my criteria for entering the long positions were invalid? No, it absolutely does not. What it does mean is that even good stocks that have just reported great news cannot fight the overall trend of their sectors and of the market in general. If any one of the stocks had been in a rising sector such as materials, metals, or energy, no doubt they would have done well. I do think that this strategy is a good one, good enough in fact to qualify for its own recipe in the Stock Market Cook Book, but with the added caveat that one only plays it according to the overall trend of the market, i.e. only go long in up markets and short in down markets– a good rule of thumb in general.

Enjoy your weekend!

Head & Shoulders Patterns – Examples & Strategies

Thursday, March 6th, 2008

Yesterday we looked at two powerful chart reversal pattern indicators, double tops and head-and-shoulders patterns. I mentioned that I would try to find some recent examples of a head and shoulders pattern, and I did. Let’s see how they fared.

The first is Stanley (SXE). It began forming the left shoulder at the beginning of last November and completed its pattern when it fell below the neckline level of $30 almost three months later. Note that volume levels surged at the top of each peak with each succeeding volume level being less than the previous one. At the top of the head, the price was around $38, so we would expect a price target of around $22 ($30 – $8). The price did reach a low of $22.68 on February 14th (Happy Valentine’s Day!) before it turned around.

The next example is Learning Tree (LTRE). The left shoulder began forming in the middle of October, the head formed two months later, the right shoulder about three weeks after that until the neckline was finally broken by a downward gap on January 22nd. The peak to neckline value was $7 giving our price target of $13. This value was exceeded by the climactic low on Feb. 19th when the stock bottomed just above $12.

You can see that both stocks exhibited all of the criteria for a successful head-and-shoulders pattern: 1. The shoulders are roughly symmetrical and of the same height 2. The volume at each successive peak declined 3. There was a big run-up in the stock prior to reversal.

Now that you can identify this pattern, let’s look at some strategies that will help you make the most out of this situation. One strategy is to simply short the stock when the price breaks the neckline and exit when it approaches its price target (If the stock doesn’t quite reach it’s target and the price is reversing on heavy volume, cover your position.) A better and much more profitable strategy is to buy put options. Let’s compare the two.

Suppose you shorted LTRE when it broke support at $19/share and covered 19 trading days later when it exceeded its price target, say at $12.50/share. The net result would be $6.50/share, or $650 on a $1900 investment. That’s a 34% gain on your investment or a 450% annualized return. Pretty darn good!

But what if you had purchased puts instead of shorting the stock? Well, unfortunately neither of the above-mentioned stocks are optionable so I’m going to have to do a rough comparison using my handy-dandy Black-Scholes calculator to compute options pricing. In the case of LTRE, had you purchased the April 20 puts, the cost would have been roughly $1.85 and you could have sold them for $7.40, a gain of $5.55/contract. Assuming you have the same $1900 to invest, that means that you could have purchased 10 contracts at a total cost of $1850. Your realized gain would then be 10 x 100 x $5.55 = $5550, a return of over 300%. The annualized gain in this case would be a whopping 3950%! If you’re in an especially greedy mood, you could also write a bear-call credit spread (e.g. buy an April 25 call and sell an April 20 call) at the same time you buy the puts. The credit you receive from the spread will offset the price of your puts thus increasing your return even more. No wonder traders love this chart pattern!

I hope you now have a clearer picture of how head-and-shoulders patterns work and a few ways to play them. When I find stocks that are setting up in this pattern, I’ll let you know and hopefully we can both profit.

It’s a beautiful day and Fifi wants to tidy up my desk, so I think I’m going to take a long walk on the beach with Moondoggie. Toodles!

Cooking Tools #1: Chart Pattern Reversals

Wednesday, March 5th, 2008

Continuing with yesterday’s introduction to chart patterns, today we’ll be looking at chart pattern reversals. These are useful tools in determining when a stock may be setting up for a reversal in price trend. Included in this discussion are double tops and bottoms and head-and-shoulders (not to be confused with the dandruff shampoo). Other reversal patterns include broadening formations and triangles, but they’re not as easy to spot nor are they as reliable.

Since there are many books and websites that discuss these patterns in depth, I’m only going to touch on the salient points so that you will be able to identify them and know what to do when you see one.

A double top or bottom looks exactly what it sounds like. A double top looks like a rounded M and a double bottom looks like a rounded W. For simplicity, I’ll discuss the characteristics of a double top; the commentary for a double bottom will be the reverse.

Characteristics: A double top occurs after a significant run-up in the stock, usually on the order of months or even years. The pattern is composed of two peaks of roughly equal height (they should be within 3-4% of each other) with a trough of about 10-20% off the peak high in the middle. The distance between the two peaks can be from several weeks to several months; too close and this could just represent normal resistance rather than a lasting change in the overall supply and demand. Once you learn how to spot a double top you’ll know the difference between a minor fluctuation and a major reversal pattern.

How to play it: After the second peak has formed, the stock will decline on increased volume and/or experience downward gaps. What you want to do is wait and see if it will break the support line which is the horizontal line that goes through the peaks and touches the base of the trough. If it does break this line, it must do so on increased volume. A general rule of thumb is to wait a few days after the break before entering a short position (or selling the stock if you were long) to see if the break is real. Once the support line is broken it becomes resistance, and any retracement back to this line can be viewed as another chance to exit your long position and/or initiate a short one.

Price target: Subtract the peak value to the support line from the support line for a price target: Price Target = Support Value – (Peak value – Support Value). It follows then that the bigger the double top formation, the lower it can be expected to go. If you had shorted just below the support line break, you can expect to cover when it reaches its price target.

A head and shoulders pattern is one of the most powerful and reliable chart reversal tools. It’s very smiliar to a double top except that it has an additional higher peak called the “head” located between the two lower peaks called the “shoulders.” The “neckline” is the support line drawn at the base of the troughs joining the head and shoulders. This line doesn’t have to be horizontal; a sloping line is okay. Volume is crucial here. The volume of each successive peak must be less than the volume of the previous one. Overall, the volume should experience a significant decline during the course of pattern formation. If you have both the shape and the volume criteria, then you have correctly identified this powerful reversal pattern. Head-and-shoulder patterns typically take a couple of months to set up, although some can take longer.

How to play it: You play this exactly the same way as a double top.

Price Target: The price target is the same as in a double top except that you’ll be using the top of the head as your point of subtraction: Price Target = Neckline (support) value – (Top of Head value – Neckline value). Note that other considerations can come into play when establishing a price target such as major support and resistance levels, Fibonacci levels (don’t worry too much about that right now), and major moving averages.

Note: Since this pattern is so reliable, it is also very profitable and much coveted by traders. It is also a rare one, but I’ll see if I can dig up a few stocks that are exhibiting this pattern so that we can follow their price action.

Getting Technical-Introduction to Chart Patterns

Tuesday, March 4th, 2008

Yesterday on CNBC’s Fast Money program, master chartist Louise Yamada gave her views on where she thinks the market is headed. She showed a multi-year chart of the S&P 500 and said that the (head and shoulders) break of its 1400 support level in early January marked the beginning of the downturn. How far does she expect it to go? Based on the triangle pattern that began near the end of last November, she feels that it can go as low as 1200. She arrived at this number by taking the difference between the November 26th price of 1407 and subtracting it from the December 11th triangle high of 1523 and then subtracting that value (116) from the beginning price (1338) of a new triangle that began forming on January 23rd. I have to say that I think her analysis might be correct. Last Friday, the S&P broke out of its current triangle pattern and is heading down. It’s nearing the 1310 support level and if it breaks that, then I believe nothing will stop a drop at least until it reaches the next major resistance level at 1235-1240.

Well, that’s all fine and dandy you say, but isn’t technical analysis just a bunch of voodoo? Yes, it is, but only when you don’t know what you’re doing. My goal is to introduce you to some basic concepts so that you will have a better knowledge of why your stocks are behaving the way they do and be able to predict what they might do in the future. Knowing how to spot price patterns, you’ll learn how to identify entry, exit, and stop/loss points. Isn’t that worth the price of a little education? I hope you’ll agree with me that it is, or at least keep an open mind about it.

Over the next few weeks we’ll be looking at price reversal patterns and price continuation patterns. A head and shoulders pattern indicates a price reversal and triangles, pennants, flags, and wedges give indications of either a price reversal or a price continuation, depending on certain conditions. These sound like formidable subjects involving a lot of math, but if you know the difference between a rectangle and a triangle and can add and subtract, then you’ve got all the tools you need. If you don’t, then your intelligence deserves to be insulted. And I’ll do my part by trying to keep it as palatable as possible. Deal?

Earnings Portfolios Update:
Good News Guys:
Down 2.6% (since inception). VISN has been the clear winner, gaining over 11%. HURC is still the biggest loser, down 13%. Had I owned it, I would have dumped it yesterday when it broke it’s Thursday’s low.
Bad News Bears: Up 20%. Thanks to recent market bearnishness, all of these stocks have been winners. However, the steam seems to be evaporating from all of them, and if I actually held these positions, I’d be sorely tempted to exit them all right now. Hey, a 20% gain in 4 days ain’t chicken feed–that’a a 1250% annualized return!

Can You Trust Your Charting Program?

Monday, March 3rd, 2008

Eke!!! That was the cry I heard last Friday afternoon from Fifi, my ex-Wall Street analyst turned domestic dominatrix. Not only does she rule over my household but she also has the task of shoring up my stock portfolios at the end of the day. Not that I expect her to do it–she just enjoys it. I think it’s her way of keeping up with the market and giving me a little break. (She does have her soft moments but she’ll never admit to them.)

From the sound of her cry you would have thought she was being attacked by a fifty foot rodent with a taste for French tarts, but it was something more sinister than that. She found major discrepancies in the end-of-day stock prices as quoted from my real-time charting program compared with what my online portfolio management program reported. She also found that what was given as the last trade on a real-time chart wasn’t what was reported as the final trade in the corresponding quote sheet where real-time profits and losses are calculated. I’ll outline one actual example that should give you a clearer picture of what I’m talking about.

As my faithful readers already know, last week I constructed two portfolios–one to track stocks that reported earnings on good news (a long portfolio) and the other to track those that reported earnings on bad news (a short portfolio). Comparing end-of-day data, Fifi found discrepancies among four of the five stocks in the good earnings portfolio. Hurco (HURC) in particular showed a major discrepancy. My charting program gave the last quote in its quote sheet as $47.90 while the portfolio management program gave $44.22, over an 8% discrepancy! Looking at the last trade of HURC on the chart, I saw that it was $44.38, certainly a lot closer to $44.22, but not even close to the quote sheet price. What went wrong and who was right?

First I called the portfolio management software company. They said they receive their end-of-day data from a large brokerage firm. Checking with two other independent data sources (one being Yahoo! finance), they were able to confirm their numbers. Whew! At least I have confidence that my portfolio profit and loss numbers are being calculated correctly. Then I called my data service provider. They admitted the discrepancy between the quote sheet and the final trade on the chart and said “they would look into it.” As to why their end-of-day data doesn’t jibe with everyone elses’s, they said that I wasn’t running the latest version of their software (which just came out and which Dimitri forgot to install), so that could be the problem. I’ll know for sure tomorrow when I compare the two software versions.

I really hope my data provider resolves the problem between the chart and the quote sheet values because errors of this sort can have consequences as to what course of action one should take. In the case of HURC, the loss should have been 8.2% as opposed to the 0.5% loss given in the quote sheet. If I were an investor operating with tight stop/loss triggers and had I seen the correct number, I might have entered a sell order at today’s market open which would have spared me another 7% loss today.

Bottom Line: What does this seemingly trivial error mean to you? It means that even software that has been around for many years and used by perhaps hundreds of thousands of users can still have errors–errors that could potentially be detrimental to the value of your portfolio. Although it’s a pain in the keister, you might want to periodically check the price of your holdings against an outside data source, especially if you’re trading intraday.

Earnings Portfolios Update: Today our Good News portfolio is down 4.5% since Thursday with Hurco being the biggest loser, dropping a total of 13%. The Bad News Bears are triumphing with a 17% overall gain. ABH and RHD have been dropping faster than Jimmy Hoffa’s body in the East River, gaining a total of more than 28% and 34% respectively.

I just hope I can trust these numbers!