Synergistic Trading Newsletter |
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www.TradingEducation.com |
February 25, 2008 |
Good Afternoon Subscribers!
U.S. stocks were rising on Tuesday as crude oil prices lifted shares of energy companies, while Wal-Mart Stores Inc's stronger-than-expected profit supported hopes about consumer spending. We are also seeing a surge in commodities prices despite murky signals about the health of the U.S. consumer and continued credit-related distress for financial companies.Prices for oil and other commodities have strengthened in recent weeks because of rising confidence that demand can remain solid in the U.S. But if demand shows signs of slipping, or if high costs gives way to higher inflation readings in the months ahead, the stock market could see a negative impact.
Following is this week's newsletter.
Warm Regards,
Lane Mendelsohn
Website Publisher
In
This Issue...
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Questions to Van
by
Van K. Tharp, Ph.D. |
2 |
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Why, When, and How to Buy Options on Futures
by
Jim Wyckoff |
3 |
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Currency/Commodity Markets
by
Kevin Klombies |
4 |
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U.S.
Stock Market Update
by
Robert W. Colby |
5 |
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Weekly Currency Wrap-up
by
Darrell Jobman |
6 |
Synergistic Trading Newsletter |
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www.TradingEducation.com |
February 25, 2008 |
Trading Psychology
Questions to Van
by Van K.Tharp, Ph.D.
What types of systems have you seen that don’t work?
In my opinion, there are certain types of fundamental analyses that just don’t work. And the major one I’d like to cover here is talking about the future prospects of a company. For example, I frequently get newsletters that talk about the potential future earnings of a company. Let’s say company ABC is a small startup company. It’s a microcap, worth about $50 million. But let’s say it has some new technology that could change the way we live our lives. Let’s say XYZ has a new drug that will allow people to eat normally (i.e., the way they’ve always eaten), yet cause them to safely lose about a pound each week while taking the drug. The idea sounds great, doesn’t it? You could buy into that sort of stock, right?
Absolutely, so how would the analysis of the stock go that would convince you to buy it and why wouldn’t it work?
First, the analysis would convince you of the potential market for this new technology. In this case, you might learn that 30% of all Americans are obese. You might also learn that another 30% of Americans who are not obese are fanatical about weight loss and would use this product if it were safe.
Second, the analysis would convert this potential market into the potential income for the product. So let’s say that 150 million people need the product and that 15 million use it regularly in the first year it comes out. Let’s say it cost $2 per dose and the average person needs 5 applications each day. That’s $10 per day or $300 per month. The analysis might say that the profit margin is about $250 per month per user or $3,000 per year per user.
Now the math begins to add up and you learn that $3,000 per year per customer in profits times 15 million potential customers equals $45 billion. This company currently has a market capitalization of $100 million and it could earn $45 billion in the first year. That suggests that the price of the stock could go up 450 times. Wow, you are really excited and you buy 500 shares of the stock at $18 per share for a total investment of $9,000.
Next, the analysis might talk about the safety of the technology and give all the evidence that suggests that it is perfectly safe with no side effects. So you have a stock with a potential of going up 450 times or more and its safe. Wow.
Okay, so what’s wrong with the analysis? What happens?
Everything is wrong. It’s mostly what I would call hype. Everyone who works in a company and produces this sort of product will give this type of analysis to the manager of the company. And the typical response of the CEO of the company is “how come we have these great new products with huge potential, but we only manage to grow our company 5-10% a year when the market is that good?”
The bottom line is that I would guess that less that 5% of these companies really take off (and that’s 5% of those that look really good to the analyst). And of the 5% that take off, I’d also guess that less than 5% of those really take off big—up 10 times or more. That means you have about a 0.0025 chance of such a stock taking off. If you risked $1,000 on each such company, then your overall expectancy is probably way less than zero.
So just be careful.
Until next week, this is Van Tharp.
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Synergistic Trading Newsletter |
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February 25, 2008 |
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Weekly Futures Market Commentary
Why, When, and How to Buy Options on Futures
by Jim
Wyckoff,
Senior Editor
n this educational feature I will discuss trading options on futures--specifically buying puts and calls. You can also sell options, but your financial risk is not limited like it is when you buy an option. I won't get into selling options in this feature.
I know that many beginning (and even veteran) traders think options trading is too complicated, and they don't have a clue about the vega, theta, delta and gamma pricing formulas--or the strangles, straddles, butterflies and other such options trading methods. Well, don't worry. I'm not going to get into those strategies in this column.
Entire books have been written on options and options-trading strategies, but I will only focus on a few basic, low-risk and limited-risk trading strategies for beginning traders (and veterans, too). I'll also briefly talk about using options to "hedge" winning trading positions in volatile markets. I do suggest that if you are interested in trading options, you should read a book or two on options trading. Again, you don't have to be a rocket scientist to employ simple options-trading strategies.
First, I am going to assume readers know the definition of an option on a futures contract, and also the difference between a put option and a call option and "in the money" and "out of the money." (If you don't know the meaning of these terms, that's okay. Just go to one of the big futures exchange websites, and you can find a glossary of trading terms, digest the options terms and then read this article.)
A while back there was a big runup in the price of crude oil. It certainly was tempting for many traders to want to short that market at those sharply higher price levels. However, remember that to successfully trade futures you not only have to be right on market direction, you also have to be correct on the timing of the market move. Furthermore, you can be right on market direction and very close to being right on timing the trade, but still lose your trading assets because of market volatility. In crude oil, for example, a trader could have established a short position two days before the top in the market was in, and still be stopped out and lose his trading assets because of the high volatility.
Purchasing options allows you to limit your financial risk and let's you ride out volatile market swings without the worry of increased margin calls.
Buying a put or a call that is "out-of-the-money" is a relatively inexpensive way to wade into futures trading. The money the trader lays out to his broker for the option purchase is all the trader has to worry about losing. No margin money. No margin calls. He can sleep well at night. And he is still trading futures, learning the business, honing his trading skills.
Here's another trading tactic to think about regarding purchasing options in volatile markets. Just because you have a protective buy stop or sell stop in place when trading straight futures contracts, that does not guarantee you will get out of the market (filled) close to your stop. For example, weather markets in the grains and soybean complex futures can produce limit price moves--sometimes for two or more sessions in a row. If you have a straight trading position on in soybeans and the market moves against you by the limit, or multiple limits, your protective stop is virtually worthless. But if you had hedged your straight futures position with a cheap out-ofthe-money option purchase, you have limited risk in a volatile market.
Let's say you are long soybeans at $5.00 in a highly volatile market. You initiated that trade on the long side, but then decided to purchase a $4.50 put option that limits your trading risk to 50 cents a bushel ($2,500 per contract), plus the price of the put option purchase. The trade-off here is that you are gaining peace of mind and losing some profit potential. But for many traders, that's well worth it. You can stay in the game to trade again another day, and won't get wiped out by a limit price move.
There are trade-offs in purchasing and trading options on futures, as opposed to trading straight futures. If you purchase "out-of-the-money" options, the market has to move in your favor for a period of time before your option becomes "in-the-money." During periods of high market volatility, the prices of options can and usually do increase substantially.
One more thing: Anyone considering trading options on futures needs to check the open interest level on the particular "strike price" they are contemplating trading. Just like in straight futures trading, the more liquid (higher open interest) strike prices and options markets are usually more desirable to trade.
That is it for this week. You can also visit my daily blog at www.traderblogs.com
Have a great week!
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February 25, 2008 |
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Commodity, Bond and Currency Market Weekly Review
Currency/Commodity Markets
by Kevin Klombies
The thesis that we are presenting today may not answer all of the questions that one might have regarding the markets but it does go some way towards explaining a few of the more obvious ones. For example, why is it that commodity prices are making new all times highs when the equity markets are falling in anticipation of a recession? Why are long-term interest rates declining even as gold prices reach record highs? Why is the bond market’s message of lower inflation so at odds with the trend for raw materials prices?
Consider that the CRB Index represents ‘asset’ prices. In response to falling interest rates asset prices have risen. Fair enough.
Consider why interest rates have declined. In large part because the banking system has moved into a state of crisis.
Why are the banks under such intense pressure? Subprime-related mortgages would be one answer.
What do subprime mortgages represent? The weakest link in the chain representing the U.S. housing market. The worst loans to the least deserving borrowers to buy real estate at the worst time and the highest prices.
What is real estate? An asset.
What broke lower first- asset (commodity) prices or the banks? Obviously the CRB Index broker lower first during the second half of 2006 with the banks turning lower a year later in the second half of 2007.
What would solve most of the problems for the financials? One answer would be strong and rising U.S. real estate prices. However, since real estate is very likely the weakest of the asset-related markets those that are stronger as represented by the CRB Index will rise first. The argument would be that the reason the CRB Index is so strong is that the markets are working very hard to inflate asset prices in general.
If the markets are trying to inflate asset prices then why are the equity markets so weak? Likely because of the yawning chasm of risk facing the banking sector starting with subprime and extending through bond insurers like Ambac and MBIA.
On Friday the U.S. equity markets turned a triple-digit loss in the DJII into a nice gain on the news of a potential bail out by the major banks of the bond insurers. This makes sense to us. The banking system faces potential losses of $70 billion if top-rated insurers lose their AAA credit ratings and, we understand, Ambac and MBIA faced a Moody’s down grade around the end of this month. A few billion in equity support now versus $70 billion in potential losses later creates a definite sense of immediacy with month end looming.
Quickly... the BUD/SPX ratio continues to flat line side ways and represents the inverse to the trend for the Canadian dollar.
The bank stocks in general and the Japanese banks in particular (MTU and MFG) have been trending with the U.S. dollar. To the extent that the commodity markets have recovered sharply over the past year to indicate higher equity markets prices into 2009 then a recovery in the banks should go with a better dollar which, in turn, might slow the pace of the rise in the CRB Index.
Short-Term Views
Today’s point is that asset prices as represented by the CRB Index turned lower in 2006 and given that the banking system is monstrously levered to rising asset prices the ponzi-like pyramid of garbage in-garbage out securitized toxic waste turned negative in 2007 leading to the subprime crisis. The markets’ response was to furiously return to inflating asset prices leading to a swing back ‘on trend’ for the CRB Index. The equity markets have been trending about a year behind the CRB Index since the start of the new millennium so the argument would be that better equity markets lie ahead. A more challenging question would be... starting when?
At top right we show the CRB Index into the start of 2007. The lows for the CRB Index were hit on January 18th of 2007 leading into a recovery that has yet to end.
At bottom right we have included a chart of the S&P 500 Index (SPX) into early 2008.
Our argument was that the commodity markets appear to be leading the equity markets by roughly a full year. The charts, on the other hand, make the case that the commodity markets may, in fact, be leading the equity markets by precisely one year. Notice that the lows for the SPX were made on January 22nd and 23rd which, give or take a few days, is precisely one year after the lows for the commodity markets.
Late Friday the FDA surprised analysts and much of the market by granting approval for certain types of applications for Genentech’s (DNA) cancer treatment Avastin. If the equity markets are to recover as we are suggesting then this is the time and place for surprisingly bullish news. This is why we mentioned the bond insurers on page 3- based on the lagged relationship between commodities and equities it is now time for positive surprises.
We continue to view bank and dollar weakness as part of the same trend with the commodity markets- including gold- working as an offset. The ratio between Mitsubishi UFJ (MTU) and the gold etf (GLD) is similar to the ratio between the Canadian banks and the Nasdaq that hit bottom in March of 2000 at the peak for the Nasdaq.
Best
Wishes,
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Synergistic Trading Newsletter |
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www.TradingEducation.com |
February 25, 2008 |
U.S.
Stock Market Update
Commodity prices rose to another new all-time high.
Technology stocks fell to another new low.
On Friday, major stock price indexes opened slightly higher but quickly turned down. Prices continued lower most of the day until the final hour, with stock price indexes below their lowest lows of the previous 7 trading days, thereby confirming a short-term downtrend. Out of the blue, at about 3:10 p.m., CNBC reported that a bailout plan for bond insurer Ambac (ABK) could be announced this in the week ahead, on Monday or Tuesday. Prices quickly shot up steeply to close above their open, previous close, and near the highest levels of the day. Clearly, the news caught many traders short. Volume on the NYSE fell by 4%, reflecting waning demand for stocks.
The market certainly appears to be quite reactive to the news, rumors, and “reports” of the day. Many of these “reports” never pan out, but they do contribute to unpredictable volatility. In the technical picture, minor and major underlying technical trends have been confirmed Bearish for stocks. In addition, most of the economic data seems to indicate that underlying fundamental trends may be deteriorating. There has been a sense that big problems are already baked into the cake, in the pipeline, and it is too late to do much about them. On the other hand, on some days at least, there still seems to be hope that the government or somebody (PLEASE!) might come up with an effective solution to the ongoing financial crisis. The markets vacillate back and forth between these opposing points of view day to day, depending on the news and rumors of the day, which leak out bit by bit, seemingly at random. This makes for a high-risk environment for stock trading, both for longs and for shorts. You don’t know what will hit next.
Looking beyond the daily fluctuation to the major trends (listed in order of long-term relative strength):
Energy (XLE) Neutral, Market Weight. On 2/20/08, the XLE/SPY Relative Strength Ratio rose to new all-time high, confirming a major uptrend.
Materials (XLB) Neutral, Market Weight. On 2/20/08, the XLB/SPY Relative Strength Ratio rose to a new all-time high, confirming a major uptrend.
Consumer Staples (XLP) Neutral, Market Weight. On 1/17/08, the XLP/SPY Relative Strength Ratio rose to new 3-year high, confirming a major uptrend.
Utilities (XLU) Neutral, Market Weight. On 1/9/08, the XLU/SPY Relative Strength Ratio rose to new all-time high, confirming a major uptrend.
Industrial (XLI) Neutral, Market Weight. On 2/13/08, the XLI/SPY Relative Strength Ratio made a new all-time high, confirming a major uptrend.
Health Care (XLV) Neutral, Market Weight. On 1/17/08, the XLV/SPY Relative Strength Ratio rose to new 2-year high, confirming a significant uptrend.
Consumer Discretionary (XLY) Bearish, Underweight. On 2/21/08, the XLY/SPY Relative Strength Ratio fell to a new 3-week low, suggesting short-term weakness. On 1/11/08, the XLY/SPY Relative Strength Ratio fell to a new 6-year low, confirming a major downtrend.
Technology (XLK) Bearish, Underweight. On 2/22/08, the XLK/SPY Relative Strength Ratio fell to a new 8-month low, confirming a significant downtrend.
Financial (XLF) Bearish, Underweight. On 1/8/08, the XLF/SPY Relative Strength Ratio fell to a new 7-year low, confirming a major downtrend.
Fundamentals: The 2003-2007 Bull Market was fed by abundant global liquidly, M&A, leveraged buyouts, corporate stock buybacks, and the net balance of positive earnings surprises. The unfolding fallout from the subprime credit market crisis has derailed that engine. Economic statistics and corporate earnings have been weakening.
The Primary Tide Major Trend turned Bearish, and that is a strong force. The Dow Theory confirmed a Primary Bear Market on 11/21/07 when both the Dow-Jones Industrial Average and the Dow-Jones Transportation Average closed below their respective closing price lows of August, 2007. On 11/7/07, the Transports closed below their 8/16/07 closing price low of 4,671.88. Then on 11/21/07, the Dow-Jones Industrial Average closed below its 8/16/07 closing price low of 12,845.78, thereby turning the Primary Tide Bearish.
To discover the next Resistance, traders probably will be watching how the market acts at the following levels for the Standard & Poor's 500 cash index (1,342.53):
Potential Resistance
1,576.09, high of 10/11/2007
1,552.76, high of 10/31/2007
1,523.57, high of 12/11/2007
1,498.85, high of 12/26/2007
1,403.45, low of 1/7/2008
1,385.62, high of 2/1/2008
To discover the next Support, traders probably will be watching how the market acts at the following levels for the S&P 500 cash index (1,342.53):
Potential Support
1,270.05, low of 1/23/2008
1,261.30, low of 8/10/2006
1,224.54, low of 7/18/2006
1,219.29, low of 6/14/2006
1,214.45, low of 11/4/2005
1,201.07, low of 11/2/2005
1,168.20, low of 10/13/2005
1,163.23, high of 3/5/2004
1,159.86, low of 5/17/2005
1,153.64, low of 5/16/2005
1,146.18, low of 5/13/2005
1,139.14, low of 4/29/2005
1,136.37, low of 4/20/2005
Best
Wishes,
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Synergistic Trading Newsletter |
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February 25, 2008 |
Weekly Currency News Trading
Weekly Currency Wrap-up
Week Ending January 22, 2008
by Darrell Jobman, Editor-in-Chief
Conditions within the US economy have continued to be a major focus over past week. Although markets were subdued early in the week, recession fears increased later in the week and further damaged dollar sentiment.
US housing starts were little changed at a depressed annual rate of 1.01mn for January while building permits edged lower. The NAHB housing index edged higher to 20 in January from 19. Jobless claims fell slightly to 348,000 in the latest week, but continuing claims continuing to edge higher which suggested that it was more difficult to get new jobs.
The Philadelphia Fed index weakened further to -24 in February from -20.9 previously. This reading was a 7-year low and put the index firmly in recession territory. Similarly, leading indicators also signalled recession conditions.
Minutes from the Fed’s January meeting pointed to the downside economic risks and the growth forecasts were also lowered with the Fed stating that relatively low interest rates would be required for a time. Inflation estimates were also increased in the report while the Fed stated that cuts could need to be reversed rapidly once the economy stabilises. Markets continued to price in further interest rate cuts.
US consumer prices rose 0.4% in January as food and energy prices increased which pushed the annual increase to 4.3%. There was a core increase of 0.3% for the month with pushed the underlying rate to a 12-month high of 2.5%.
There were further rumours and ratings stresses surrounding the US bond insurers and this triggered important shifts in sentiment as equity markets also found it difficult to sustain trends for long.
There were further downgrades of the Euro-zone 2008 GDP growth forecasts, although the market impact was limited. The preliminary PMI reports for the manufacturing and services sectors were both at 52.3 for February which provided some relief over near-term economic trends.
The Euro-zone current account moved into deficit for December with a shortfall of EUR10.3bn which raised some concerns over deteriorating competitiveness.
The dollar pushed to near 1.46 against the Euro on Monday, but failed to sustain the gains and weakened to lows near 1.4850 following the weak economic data.
Carry trades struggled for direction over much of the week. Increased fears over the US economy and credit fears were offset by general resilience in the equity markets.
The yen strengthened back to near 107.0 against the dollar on general US weakness while the Swiss franc strengthened back to highs around 1.0850
The Bank of England minutes from the February MPC meeting recorded an 8-1 vote for a cut in interest rates of 0.25%. Blanchflower dissented and called for a more aggressive 0.50% cut as a precaution against a severe slowdown.
The retail sales data was stronger than expected with a monthly increase of 0.8% which pushed the annual increase back above 5.0% given the weak release in January 2007. Prices were still lower over the year as discounting prevailed.
Sterling weakened to lows below 1.94 against the dollar during the week, but recovered back to levels above 1.9650 as the dollar stumbled. Sterling found support around 0.7580 against the Euro, but with net losses for the week.
The Australian Reserve Bank’s minutes from February’s meeting were generally hawkish with a suggestion that a 0.50% rate increase was considered at the meeting due to inflation concerns. Bank officials also took a generally tough stance on inflation and monetary policy during the week which pushed the Australian dollar above the 0.92 level against the US dollar.
In contrast, the Canadian currency was generally on the defensive with strength in commodity prices offset by expectations of lower interest rates. Weaker than expected data pushed the Canadian dollar to lows near 1.02 against the US currency.
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