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Stock Market Investing

November 29, 2006

The Smart Profits Report: Issue #374
Wednesday, November 29, 2006

Stock Market Investing: 3 Things Investors Must Master To Improve Their Trading
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

Poker champion Puggy Pearson once said: “Ain’t only three things to gamblin’: Knowing the 60/40 end of a proposition… money management… and knowing yourself.” Truer words were never spoken. And in fact, if you substitute the word “tradin’” for “gamblin’,” the same logic is true within stock market investing.

Back in 2004, I gave a keynote address at a conference, entitled, “The Three Pillars of Investment Success,” which were the same three areas listed in Puggy’s quote above. But Puggy puts it much more eloquently and succinctly than I did!

Pearson was a world champion poker player and the father of the modern poker tournament format. (So you have him to blame for the fact that you can’t turn on the TV today without seeing a No Limit game!)

He obviously understood the critical aspects of the game well - aspects that can also be applied to the investment world. There are three things investors must master - so let’s look at them today and see what specific things you can do in each area to improve your trading and investing profits now.

Master These 3 Core Concepts to Maximize Your Profits

In school, learning the “three R’s” has always formed the basis of a solid education. Until you learn readin’, writin’ and ‘rithmetic, there’s no use working on much else. The same is true in trading. These are the three most important core concepts. And it’s vital that you nail them in order to maximize your profits:

  • Know The 60/40 End Of The Proposition: You have to have an edge - but what exactly is your edge in each trade? So many people enter a trade or investment without knowing and understanding exactly why the odds are tilted in their favor. But if you know your edge, you can have the confidence to stick with an individual trade or with the trades within a system - even when things aren’t going well.

What To Do Today: Revisit your trading system or trading plan. Identify the market conditions where the system should be very strong, and the conditions where it might not perform so well. With this key information, you can approach every trade with more understanding and confidence.

  • Understand Your Money Management Strategy: You have to be able to protect your money long enough to realize your edge and take advantage of the times when you’re doing well. But many traders don’t have a money management strategy. They trade the same number of shares or contracts, regardless of the trade’s risk profile.

What To Do Today: Define a strategy that allows you to allocate your risk equally for each trade. This means that you trade more contracts or shares when the risk of loss per share is lower (meaning that your stop-loss point is closer) and trade fewer shares or contracts when the risk of loss per share or contract is higher.

  • Commit To Working On Your Personal Trading Psychology: Every great poker player, golfer and trader knows the link between knowing their personal psychology and performance. And great traders have always stated that 60% to 90% of trading is knowing and understanding your own psychology. But there are a huge number of people who believe that if they just find the right system or newsletter, then they won’t have to worry about anything else. Unfortunately, nothing could be further from the truth. Trading is such a counter-intuitive game that almost everyone who studies it concludes that success is 60% to 90% related to mastering your personal psychology.

What To Do Today: Find a good set of resources to help you develop your trading. My personal favorite is Dr. Van Tharp’s “Peak Performance Home Study Course,” find more information about this here.

Like every savvy speculator, we need to pay attention to each of the three key areas of trading in order to get the most from our investments.

Great trading,

D. R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • Once you’ve read over the three core concepts of investing, you might want to check out another issue I wrote about how to avoid three common investment mistakes in Smart Profits #371, Asset Protection Plan: How To Avoid 3 Mistakes That Could Cripple Your Investment Account.

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The Chart of the Week

Archer-Daniels-Midland (NYSE:ADM) vs. Corn Futures

This chart shows the relationship between 100 shares of Archer-Daniels-Midland (NYSE: ADM) and contract of corn futures. In August, I recommended shorting this ratio, because of the fervor over ethanol and how it was only being reflected in the distillers’ price, while the corn farmers were getting the short end of the stick.

As predicted, this ratio continues to drop - and is now reaching a stretch point on the other side. With the continued demand (artificially induced or not) for ethanol, I think this ratio is set for a bounce to the upside. My good friend and fellow Smart Profits Report analyst and commodities expert Lee Lowell agrees (at least on the corn side of the equation) and is bearish on corn for the short- to intermediate-term.

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Merger Mania

November 22, 2006

The Smart Profits Report: Issue #373
Wednesday, November 22, 2006

Merger Mania: 4 Ways To Profit From $60 Billion In 48 Hours
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

It took only a 48-hour period recently to rack up more than $60 billion dollars through buyouts from merger mania.

That’s a lot of scratch.

In fact, that’s more money than the total Gross Domestic Product (GDP) of 70% of the 181 countries that are members of the International Monetary Fund. Indeed, Borat’s “own” resource-rich Kazakhstan had a GDP of only $56 billion in 2005.

With so many companies getting bought and sold in a very short time, what does that mean for us as traders and investors? Plenty - including the fact that stock prices are racing higher, and investors are doing almost anything to chase higher yields.

Let’s look at the drivers for this recent spending spree and what we can do not only to protect ourselves, but profit, too.

M&A Feeding Frenzy: Partying Like It’s 1999…

In the leveraged buyout boom of the late 1980s, the driver was massive amounts of debt (in the form of high-yield or “junk” bonds). In 1999 and 2000, the bulk of merger and acquisition (M&A) activity was largely driven using tech companies own money - in the form of over-inflated stock shares.

But the 2006 M&A feeding frenzy features the best of both worlds. Stock prices are currently soaring, with the Dow at all-time highs and the broader indexes at multi-year highs. This gives companies high book values and financial leverage.

But the even bigger driver for this current round of buyouts is a chase for yields that would make former junk bond king Michael Milken proud.

There are really only two ways to buy something:

  • Using money you’ve made.
  • Or money you’ve borrowed.

And companies are borrowing money like never before.

The Wall Street Journal reports that at least two companies have made their buyouts with so-called “toggle” bonds - a type of bond that is every bit as risky as it sounds. They allow companies to borrow money on the premise that they can repay the debt either with company cash flow (the old fashioned way) or by issuing more bonds (the new fangled leverage-to-the-hilt way).

And the Wall Street Journal reported today that the value of leveraged buyouts in 2006 has already eclipsed total M&A value of 2000. All of the sudden, the current round of M&A activity starts to sound like a merger mania.

What to Do When Things Start To Look Too Rosy

When companies start buying others at a clip that outpaces the most torrid in history, we should take notice. And when they do it using leveraged borrowing strategies that would make even the most jaded home lender blush, I want to make sure I have a tight grip on my wallet - and my portfolio.

Here are a few things you can do to protect yourself - and even profit - from the current frenzy:

  • Be Very Careful Looking For a Top:

If you think things are getting a bit too heated up and that the market has to correct down, I’m with you. BUT… don’t get too excited about selling positions or jumping on the short side just yet. The lessons of past tops show us that the market can remain overheated (and even overbought) for a long time. There are some good cycle analysis reasons to look for a reversal in the next few days. However, you need some significant price moves off of these tops to trigger any portfolio rebalancing.

  • Remember: Price Moves Are Over-Exaggerated At Stretch Points:

I wouldn’t be at all surprised to see a blow-off top during this current move. The market has enjoyed consistent strength for six weeks… M&A activated is reaching a fever pitch… and retail investors may still get to frenzied participation. When things heat up like this, we can reasonably expect to see some wild moves - both up and down - before the market decides whether it will continue its march upward or take a plunge.

  • Don’t Over-Indulge In High-Yield Instruments:

Having some exposure to high-yield instruments (a.k.a. junk bonds) is a good practice - especially when there is so much capacity in the market at present. HOWEVER… remember that things ended badly, and suddenly, when the bottom dropped out of the junk bond market at the end of boom in the 1980s. Moderation is the key word here - don’t stay overexposed in this area.

  • Keep An Eye On Investment Banks:

Who consistently has the most to gain when M&A activity is hot? The answer is the investment banks that broker deals, handle due diligence, etc. So keep an eye on Goldman Sachs, Lehman, JP Morgan Chase and the other top players - because trouble in the M&A world will be quickly reflected in their share prices. Until then, look for their prices to continue strengthening.

Frothy merger & acquisition activity is a both a result of strong markets - and an early indicator of over-extension. But make sure you look for confirmation from technical analysis indicators and other market activity before deciding that the market has topped out.

Good Trading,

D.R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • While a soaring stock indexes and frenetic M&A activity certainly shows that the market is vibrant and strong, this is the time to stay alert - because corrective shocks can, and often do, occur quickly. In an earlier issue I wrote about how when the market is awash with good news, it’s often better to “sell at the sound of trumpets.” Check out Smart Profits #335, The Stock Market’s Reaction to Good News: Why It’s Best to Sell at the Sound of the Trumpets.

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The Chart of the Week

Palm One (PALM) signals between up & downside

Palm One (NASDAQ:PALM) is being sued by NTP - the same folks that took on RIMM (and the Blackberry device fueled by their technology). But RIMM came out smelling like roses, and has notched up new highs for weeks now. With a gadget-hungry society heading into the Christmas gift-giving season, it’s prudent to buy Palm on any pullbacks to its strong support level at the $14 area. A break to gap resistance just above $17 should signal upside for Palm.

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Gasoline Prices

November 17, 2006

The Smart Profits Report: Issue #372
Friday, November 17, 2006

Gasoline Prices: How To Win Big In The “Ethanol Decade”
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

This time next week, the majority of Americans will be waist-deep in Thanksgiving celebrations and likely in the midst of digesting a fat turkey and generous dollop of pumpkin pie. But that might not be all you’ll be digesting…

If, like millions of others, you’ll be traveling to your relatives’ Thanksgiving bash this year, you’ll again have to contend with gasoline prices that are distinctly unappetizing. Call me a cynic… but wouldn’t you know it? No sooner are the mid-term elections over… gasoline prices in eight of the nine U.S. regions (as measured by the Energy Information Administration, a branch of the U.S. Department of Energy) have mysteriously crept up a few cents per gallon - despite oil prices continuing to fall to under $57 a barrel. Hmm…

The national average price per gallon of gasoline is now $2.23 - meaning consumers are still feeling the pinch in a bad way. And while I’d hate for you to endure any acid indigestion thinking about that this Thanksgiving, the fact is… it could get worse.

But as much as the gasoline companies want to empty out your wallet every time you fill up the tank, there is fortunately a way you can combat this…

Demand for Gasoline vs. Demand for Oil

Demand for gasoline is actually more prone to wild swings than demand for crude oil. Why? Because few countries have the ability to refine crude for use as gasoline. That adds an extra layer of time and cost to gasoline inventories and production.

Consider that countries like Iran, which pumps out more crude than 80% of the rest of the world’s producers, must re-import their own crude as gasoline because of limited refining capability.

Here in the U.S., the situation, while not as dire, is pathetic. And it could mean “barrels” of profits for the companies solving this problem…

OPEC’s Market Manipulation of Gasoline Prices

For all the talk about America freeing itself from the shackles of the Middle East oilmen and gaining greater oil independence, the country hasn’t built any new oil refineries in more than two decades.

But building a refinery is no easy thing - it takes years and lots of environmental studies and approvals before a refinery can start producing gasoline. There are a couple of refineries on the board right now, but the first drop of gasoline from these proposed facilities is years away from your gas pump.

Naturally, politics is also a major factor in gasoline production. Since it’s derived from crude oil, much of the world is at the mercy of the OPEC oil cartel that can play havoc with supply and demand.

And because crude prices are determined at the margins, it’s not the first 30 million barrels a day that determines the price; it’s the last million barrels. And if those last million barrels are taken off the market, you’ve got a simple supply-demand equation at work: The price of crude can spike because there are no substitute sources available.

But OPEC doesn’t have to control all the oil - in fact, the U.S. gets most of its oil from Canada, Mexico and Venezuela. But when OPEC opens or closes the oil spigots, the price reacts because the cartel controls the oil that can be pulled off the market during peak demand or supply. Right now, we’re in peak demand… thanks largely to China and India’s mega-consumption.

China in particular needs gasoline to power its tremendous growth. This is an additional demand that simply wasn’t around a decade ago. But today, demand from China - a country growing at more than 10% a year - is tugging at the margins.

Ethanol: Gasoline’s Alternative Energy Solution

There is no room for error or natural disaster in the crude oil market. Sure, you may see some short-term fluctuation, but that does nothing to address the long-term demand for crude oil and gasoline. And that demand is not projected to slow - rather it is expected to outstrip the ability to produce more oil.

Therein lies the long-term problem… and the long-term solution: Alternative energy. So far, only one form of alternative energy has proved economically efficient - ethanol.

Ethanol, which is energy derived from non-carbon sources, can be produced in mass quantities around the world. It can be used with current engine technology with few modifications - there is no need for battery technology, hydrogen fuel cells, etc.

Ethanol is here now - and it represents one of the best long-term alternative energy solutions. Countries like Brazil are already ethanol dependent, and almost fossil fuel independent. And the resource has the firm backing of some of the biggest governments and private investors in the world (Bill Gates and Sir Richard Branson, to name just two).

Is There an Ethanol Downside?

Yes, ethanol has it downsides. For a start, it has to be transported by wheel technology, because there are no ethanol pipelines yet. The fuel must then be dispensed through special hoses and pumps developed to withstand ethanol’s unique chemical features. Cars and trucks must be modified or built to use ethanol.

Fortunately, those issues are being addressed in real time. And within the next decade, ethanol could end up replacing 12% of the gasoline market. And if enough money is poured into ethanol development, it’s feasible that ethanol could completely replace gasoline within 20 years. If you think that seems unrealistic, Brazil has shown that it can work. For the U.S., even a 25% replacement rate would achieve significant environmental and economic savings.

There are several companies that are top players in the field. Some are pure producers - but as such, and considering they’re in the developmental stage, they’re consequently prone to huge swings in volatility.

You could also buy a company that is a major agricultural and ethanol player. But the bottom line is that to invest in ethanol, you must have a three- to five-year time horizon. And as we’ll see in the “ethanol decade,” the potential returns are incredible.

Good trading,

Karim Rahemtulla

P.S. This past summer, I recommended a “stealth” ethanol play that not only makes money from a huge ethanol interest it owns, but also has other investments to soften ethanol-related volatility. Third-quarter earnings ballooned 41% year-over-year, allowing it to offer a $3.52 annual dividend (8.1% annual yield). What’s more… it boasts $7.8 billion in assets… a market cap of $6.3 billion… and a P/E ratio of just 8.

In a special report from myself and the investment professionals at the Xcelerated Profits Report, we’ve outlined this and other several ethanol-based companies and show you how to play the “ethanol decade.” Each company has its own set of characteristics that will appeal to all types of investors - conservative, speculative and those in the middle. Get all the details here!

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Today’s Smart Profits Cribsheet

  • Back in August, the Smart Profits Report team participated in an enlightening “Ethanol Forum,” where each editor gave his own particular take on the industry… it’s history… its upside and downside… and its prospects going forward. Educate yourself on this burgeoning industry today in our two-part series: Ethanol Investing, Part 1 & Part 2
  • D.R. Barton, Jr. gives further details about ethanol, the hottest topic since solar energy in Smart Profits #344, Ethanol’s Government Intervention: Why the “High-Growth” Ethanol Business Matters to Investors.

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Asset Protection Plan

November 15, 2006

The Smart Profits Report: Issue #371
Wednesday, November 15, 2006

Asset Protection Plan: How To Avoid 3 Mistakes That Will Cripple Your Investment Account
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

It’s the single biggest reason why people blow out trading and investing accounts. And most people never see it coming until it hits them like a runaway bus. What is this killer “it” - the thing that eats accounts, hopes, dreams, and cash with indiscriminate ease?

Before I just blurt “it” out, I’d like you to think about your personal situation, and what one, single bad habit has caused you to lose big chunks of money over and over again? Because if you’re like the vast majority of traders and investors, your personal story has “it” at the core.

The “it” I’m talking about is failing to get out of a bad trade when you should, and simply letting your losses run because you don’t have a solid asset protection plan.

It’s the world’s biggest account killer. So today, let’s look at how this cripples many investors - and more importantly, ways in which you can separate yourself from the crowd, and combat this universal problem.

Are You Making These Three Account-Killing Mistakes?

As a trading coach, I’ve had the honor and pleasure to train and teach thousands of traders and investors over the years. And over that time, there is no doubt that letting losses run is the single biggest killer in the investment world.

Are you making this critical mistake? The first problem is that some people don’t realize they are letting their losses run. So here’s a partial list of how this problem might show up in your trading and investing:

  • Having No Exit Plan: Too many people still enter trades or longer-term positions with little or no idea of how they’re going to get out. And if you have no plan, then any size of loss on that trade seems acceptable at the moment.
  • Ignoring The Plan: Many folks start with an exit strategy (good for you!) and then as they get close to the stop-loss point, they move, cancel, or ignore the stop-loss.
  • Changing The Plan - For The Wrong Reasons: I’ve heard countless stories about people who’ve entered a short-term trade and then held on much longer when things went against them. For example, there are times when a day trade moves the wrong way and the trader hangs on overnight, hoping for some help at the next day’s open. But then it gaps against them in the morning, and the day trade turns into a long-term position trade - all because the person wouldn’t honor their original stop.

Three Simple Steps To Avoid Big Losses

Here’s an easy-to-follow, three-step process that will send you on your way to eliminating those big losses in your account and helping you create your own asset protection plan.

  • Develop a Trading/Investing Plan: Before you enter a trade, it’s critical to have a plan that tells you when and why to get out. The reason why is so very important, because it’s the anchor that allows you to stick to the plan when your stop loss is hit, and keeps you from moving or ignoring your stops.
  • Stick To Your Plan: Once you have a “get out” point, you have to honor it. This is the step where many stumble, because the “need to be right” kicks in. They have a plan that tells them when they should get out of the trade… but they don’t. The most useful trick that I’ve found to beat this is to write all of your stop-loss points on a sheet of paper. This makes a stronger psychological commitment to yourself, and makes you much more likely to honor your stop-loss point.
  • Use The Right Position Size: Even if you make a plan and stick to it, you can still suffer some really big losses if you trade in sizes that are too big for your account (too many shares or too many contracts). Make sure that your worse-case loss for each trade or position would be no bigger than 1 or 2% of your account, and you’ll be on your way to long-term trading success!

Good Trading,

D.R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • Back in September, the Amaranth hedge fund proved to every investor just how important it is to make sure you manage your risk properly and have a good exit strategy in place in case the worst happens. In just one week, the fund limped away with a $4.5 billion loss under its belt. Make sure you follow the simple tips I provided in Smart Profits #355, Risk Management and Position Sizing: Three Ways To Give Your Trades A Tune-Up… and make sure a similar fate doesn’t befall you.
  • Don’t forget to check out Smart Profits #363, Trade Small… Save Big: The Single Best Piece of Trading Advice Ever in which I offer new traders a remarkably simple, yet powerful message for investing within today’s fast moving and volatile markets.
  • For something completely different check out Smart Profits #352, How Derivatives Work: Use the Options Boom to Beef Up Your Leverage by Mt. Vernon Research Investment Director Karim Rahemtulla and delve into the world of derivatives; what they are, how they work and how you can use them as leverage towards massive gains within the markets.

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The Chart of the Week

Support and Resistance Study: As you can see from the chart below, Broadcom (Nasdaq: BRCM) has just broken above an intermediate resistance level. From here, we can reasonably expect that it should move toward $40 - its next key resistance point.

Broadcom breaks an intermediate resistance level!

But if it’s a false breakout, we’d be seeking the $26.33 level. Which will it be - a real breakout or a false one? The broader semiconductor index should give us some clues: Neither $SOX or SMH have broken above their October highs yet. If they do in the next week, then BRCM is a good bet for a bullish breakout; if not, be very cautious from the long side.

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The Breakdown Of A Covered Call Trade

November 10, 2006

The Smart Profits Report: Issue #370
Friday, November 10, 2006

The Breakdown Of A Covered Call Trade: How You Can Get Paid For Holding StocksBy Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research

I have a question for you: Are you making as much money as you can from your stocks? By that, I mean: Are your stocks just sitting in your account waiting to go up in price?

If so, it doesn’t have to be that way. Did you know that other investors will pay you cash today in exchange for the opportunity to possibly take your stock from you at a higher price sometime in the future? That’s right - you can earn passive income just because you have some shares sitting in your account.

Let’s see how it works through the breakdown of a covered call trade - showing you how you can put more money in your account today for holding those stocks…

The Anatomy Of A Covered Call Trade

If you own at least 100 shares of stock in your account, you have the opportunity to sell a covered call option against those shares.

What does that mean?

Basically, you can sell one call option (one option contract equals 100 shares) against the shares of the company you own to an option buyer.

In doing so, you’re giving up the right to own the shares to the person who buys the option from you. And when he buys, he now has the right to buy the shares from you at a pre-determined price (the strike price). For that right, he must pay you money - yours to keep, free and clear, no matter what happens in the future. That’s your return.

If the stock moves up past the strike price of the option you sold, you will then be obligated to sell your shares of stock to the option buyer at the stated strike price. Is that a bad thing? Not if you do the trade correctly, and have a price in mind that you would be willing to sell the shares anyway.

Let me give you a real-life example of how this covered call trade works…

Forget “Buy And Hold”: How My Folks Squeezed Extra Profit From IBM

My parents both own 800 shares of IBM that they’ve held for many, many years. Over that time, they’ve obviously experienced the ups and downs - but have still not cashed out of the stock.

But now, they’ve finally decided that if they’re going to sell their IBM shares, it’s going to be when the stock hits at least $95 or higher. Fair enough. But instead of simply having them enter a sell order limit at $95, I got them to sell some covered calls against their 800 long shares at the $95 strike price instead.

Since each option contract is the equivalent of 100 shares of stock, my parents sold 8 call option contracts each. Take a look at the IBM chart below:

Selling 2 Sets of Covered Calls on IBM

We sold the first set of call options on March 17, 2006 - selling the January 2007 $95 strike calls for $1.95 each. That brought in an immediate $3120 (16 x $1.95 x $100 multiplier = $3120) into my parents’ accounts.

We chose the $95 strike calls because if IBM ever happened to trade above $95 by option expiration in January 2007, my parents would get the stock called away from them at that price. So instead of sitting around, waiting and hoping for IBM to eventually move back up to $95, they got proactive with their portfolio, sold some calls and made easy cash.

A Simple Buyback Worth $2,880

Since we’re never obligated to hold onto a call option, we decided to buy back the calls in the middle of July 2006 in order to take a profit on the option side of the trade. Even though IBM was moving down in price (and causing a paper loss on my parents’ long stock), the call options were getting cheaper too, giving us a gain on those.

We bought all the calls back for $0.15 each, which cost us $240 total (16 x $0.15 x $100 multiplier = $240). So in essence, we locked in a real-life gain of $2,880 ($3120 - $240 = $2,880). Sweet!

Since we bought the options back, we were left with no more obligation to sell IBM at $95/share. My parents had their 1600 shares of IBM just sitting in their account again. So what now? We wait for the next call option selling opportunity…

The Ride To $95 Is Much Sweeter With $4,800 In The Bank

That occurred about three months later, after IBM gapped up to $92 per share on October 18, 2006. Because IBM had rallied back by $18 higher per share, it was a good time to sell more calls.

My parents opted to sell the April 2007 $95 calls this time and collected $3.00 per option, which brought in another cool $4,800 of quick n’ easy money. Now all they have to do is sit and wait to see if IBM gets to, and then stays above $95 per share by the April 2007 option expiration.

If it does, they will sell their shares for $95 and walk away with no more position. If IBM stays below $95 at April expiration, the calls will expire, and my parents will keep their IBM shares and will look to do another trade sometime in the future.

So you can see that the covered call strategy is a sound and easy way to bring in extra cash every few months of the year into your portfolio. If you have stock sitting idle in your account, and have a pre-determined sell point, don’t just wait for the stock to reach that level, sell call options against your stock at a strike price that coincides with your sell point. Make your stocks work for you, instead of you working for your stocks.

Good Trading,

Lee Lowell

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Today’s Smart Profits Cribsheet

  • Mt. Vernon Research Investment Director Karim Rahemtulla explains his own strategy for writing covered calls, showing you how you can “rent” your stocks, and gain income from them at the same time. You can get the details on covered calls now in Smart Profits #128, Writing Covered Calls: How to Double Your Stock Profits with Options.
  • And Karim should know. He’s a master of the covered call strategy (in fact, he’s got an entire trading service dedicated specifically to it - The Income Trader. Get more details!

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Get The Entry Price You Want

November 8, 2006

The Smart Profits Report: Issue #369
Wednesday, November 8, 2006

Get The Entry Price You Want: The 3-Step System To Magnify Your Profits
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

Everyone gets excited whenever their system, newsletter, or investment advisor gives a new entry signal. It’s just human nature. The moment is pregnant with possibility and the anticipation of profits. But this excitement causes many people to jump into a trade at the wrong time when trying to get the entry price they want.

Many trading systems or investment services (especially ones with a longer-term focus) give signals for an “at the market” entry. Trouble is… if the stock is having a good move in your direction, you can end up chasing the price and paying much more than you should for the stock or option.

If an investor does this enough times over the course of the year, it can seriously eat into profits.

That’s why one of my favorite trading tactics is to “make the market (or the stock) come to me” instead of chasing after it. So let’s see why this works and how to do it…

Avoid “At The Market” Profit Erosion: Shop For a Better Price

Here’s an observation that always amazes me: People will spend more time shopping for the best price for a new digital camera than they will for a new stock trade.

Just last week, a friend of mine told me about the elaborate plan he followed in order to find the best price for a new camera. It involved browsing his favorite online stores, using Internet shopping “bots” (sites that search hundreds of online retailers for the best price), and then taking the results of these searches as ammunition to use while haggling with local retailers. I was exhausted just listening to him!

And all this was to save 30 bucks on a $300 camera!

Yet I know people who will buy 1,000 shares (or more) of a stock “at the market” just because they got a new buy signal from their investment advisor, or trading system. But if the stock runs just a little bit before your order is executed, you could end up paying much more than the price of that digital camera, just for the convenience of having your order filled now.

Don’t do it. There’s a better way to get into trades…

The 3-Step System To Getting The Price You Want

Here’s the three step process that subscribers to my E.S.P. trading service use to get the preferred entry prices on their trades, and jack up their reward-to-risk ratio at the same time. And far from chasing an asset’s price, it’s all about making the stock “come to you.”

  • Separate The Entry Signal From The Desired Entry Price

I know very few traders who take the time to do this - but almost all the ones that I know are professional traders. So why not be like them? The first thing we do is make sure that our system has a clear entry signal. Once that signal is triggered, we then add one more critical step - determining the best entry price we can reasonably expect to achieve (this is determined by using a combination of technical and quantitative analysis. But you can also use a simplified version by looking at chart support and resistance levels and intraday ranges).

  • Test The Entry Price Range Versus Our Reward-To-Risk Requirements

Once we determine the entry price we want to achieve, we determine a range around that price where we would accept a filled position. Then we make sure the price range gives us a preferred reward-to-risk ratio. We look at a minimum ratio of 2:1, but also scan for opportunities with much larger ratios. If it passes that test, the buy signal alert is issued.

  • Exercise Patience While Waiting For The Price To Trade Into Our Range

Now for the tough part. In the middle of the excitement of a new buy signal, we have to wait for the price to trade into our preferred range. It’s this entry discipline alone that gives us a huge edge over most traders. To give you an example that illustrates this… I recently issued an E.S.P. trade recommendation on a well-known retailer. We waited less than a day to get an entry that was about 3% better on the stock price and almost 40% better on the near-term option price! That’s huge - and a great way to make patience pay off.

Great trading,

D.R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • Want another great tip for always keeping the market makers on their toes, and getting filled at the entry price you want? Mt. Vernon Research Investment Director Karim Rahemtulla gives it to you straight in Smart Profits #285, Limit Order Discipline & Two Other Simple Rules For Making Money In Options.

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The Chart of the Week:

A major resistance level forming on PMC Sierra

PMC-Sierra (Nasdaq: PMCS) has endured a rough time this year. As it struggles to regain its footing, a major resistance level has formed at the $7 area - one that has held since August. Look for a sell sign here for at least one more pullback. A close above $7, however, could send the stock back to test $9 pretty quickly, though that is the less likely scenario.

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The Strongest Six Months of The Year for Stocks

November 3, 2006

The Smart Profits Report: Issue #368
Friday, November 3, 2006

The Strongest Six Months of The Year for Stocks: Will The Market Spring A Cyclical Surprise?
By Jim Stanton
Technical Analyst, Mt. Vernon Research

The stock market usually goes through a number of different cycles each year - and right now, it’s headed into what is historically the strongest six months of the year for stocks.

As we approach the end of 2006, the market has actually followed a few key trends.

  • At this point, we’re at the end of the much-publicized “Sell in May and go away” period - the six-month spell from May to October that is traditionally the worst time to own stocks.
  • And true to form, just about all the indexes made significant highs around May 7, then proceeded to sell off heavily for the next two months, as if they were following a script.
  • The next phase in the annual cycle is the annual summertime rally, which began right on schedule about mid July, and usually lasts until late August or early September.

But that’s when things changed. So let’s see how events unfolded differently - and what the market has in store for us next…

No September Swoon This Year… So What Does The Market Do For An Encore?

If you’re like me and like to look at the market from a technical analysis standpoint, you’ll know that for the last couple of months, it’s deviated from its normal routine quite dramatically.

And it’s provided technical analysts with an intriguing set of circumstances.

Once the summertime rally ends around late August, it ushers in another downward-cycle phase that usually bottoms out between late September and early October (hence the reason why September is historically one of the worst months of the year to own stocks), right before the traditional “year end” rally begins.

This downward trend is especially true during mid-term election years - and the supporting data for this stretches all the way back to 1950. But so far, the market’s behavior during the current mid-term election year cycle has been the exception to the rule.

The rally that began in July has proved to be very strong, with the Dow, S&P 500, and NASDAQ Composite all making new highs for the year. Investors have plowed into the market with such gusto that we haven’t even seen a decent pullback over the September-October timeframe. This has caught many students of the market off-guard.

So with such a rapid upward run, where does the market go from here?

Six Months Of Strength… Starting Now?

As I mentioned, stocks are now entering what is historically the best six-month period of the year to own stocks. To support this, take a look at the chart below, and you’ll see how it perfectly illustrates that investing in the S&P 500 on the last trading day in October until the end of April has accounted for the vast majority of the index’s gains since 1950. While there are some noteworthy exceptions (1973-74 & 2000-01), the overall outperformance is compelling.

The best 6 months of the year to own stocks

Chart Courtesy of Chart Of The Day

But Will Market Spring A Cyclical Surprise?

But here’s the problem - at least from a cyclical standpoint: Since the S&P 500 bottomed out this summer, it’s climbed around 14% - a great performance by any measure.

So if the markets are now about to enter their best six months of the year, is this just the beginning of a “super” bull market? Or since the market has strayed from its normal cycle pattern, are we in store for another cyclical surprise?

Well, while it’s still a little too early to tell just yet, I can tell you that having studied market cycles over the past several years, I’m seeing what I call a “cycle inversion.”

Wall Street’s Self-Perpetuating “Cycle Inversion”

When this occurs, you basically get a cycle low that actually turns out to be a cycle high, and a cycle high that turns out to be a cycle low.

Cycle inversions generally occur once investors become aware of them and begin to position themselves accordingly. It’s possible that this year’s traditional mid-term election selloff was short-circuited because the cycle theory has become more popular. And on Wall Street, once something becomes popular, it no longer works as well.

I’ll give you an example: Throughout September, despite the strong rally, the put/call ratio stayed abnormally high. That means investors were expecting a selloff, thanks to the talking heads on television - and consequently bought a lot of puts.

The put/call ratio is a contrary indicator, based on the premise that the public is usually wrong. So when the September selloff didn’t materialize, investors had to cover their short positions - a situation that pushed stocks even higher through October.

So pay close attention in September-October 2007. Investors will remember how things have unfolded this year, and if you see a lot of call buying, we can then again expect the normal September-October selloff.

A Case For The Bulls And The Bears

One thing I do know is that after seeing an uninterrupted rally of 14%, the market is overbought on many technical levels, and is at least due for a consolidation phase, if not a pullback or correction.

The proprietary cycle program I use shows the cycles topping out around now, give or take a week or two. And another cycle analyst whose work I respect is calling for a top between November 6 and November 13.

That leaves us with two questions: How do we deal with the conflicting cycles? And will the normally best six months of the year turn out to be a bust? Let’s look at the bullish and bearish scenarios…

  • Bullish: The Dow, S&P 500, Nasdaq Composite, and all three of the major European indexes are sitting at new highs for the year. It appears that at least the European indexes have a bit further to go, and if the Nasdaq 100 can make a weekly close above its 2006 high (1,761) the rally should continue - especially if the smaller-cap indexes follow suit.
  • Bearish: The Dow and S&P 500 have already reached their minimum upside objectives, and after a great run, are now set up for sell signals. The Dow Transports are still more than 6% away from making new highs for the year and if they don’t, it sets up a potential Dow Theory sell signal. If the Nasdaq 100 and smaller-cap indexes fail to make new highs, it sets up additional bearish divergence.

With so many uncertainties, the simplest form of technical analysis is price action. So let’s do a quick breakdown of the S&P 500…

Uptrend line from July Lows Currently at 1350

Chart Courtesy of Trade Navigator Software: http://www.genesisft.com

As shown, the uptrend line from the July lows is currently at 1,350. But this will move up, and the uptrend will stay intact until we see two closes below the trendline.

If that occurs before the Dow Transports, Nasdaq 100, and the smaller-cap indexes make new highs for the year, it should lead to additional selling - possibly a severe reversal. But if the price action stays above the trendline, the rally can continue.

Good Trading,

Jim Stanton

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Today’s Smart Profits Cribsheet

  • A key part of my technical analysis centers on chart pattern recognition. It’s an extremely useful tool that allows investors to identify important trends. One such trend that I mentioned in today’s message is “consolidation patterns” - which usually occur after a major move up or down. Get the lowdown on one type of this pattern in Smart Profits #317, Continuation Patterns: Cashing In On Technical Analysis.

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Technical Analysis Indicators

November 1, 2006

The Smart Profits Report: Issue #367
Wednesday, November 1, 2006

Technical Analysis Indicators: Harness The Power Of Leading Indicators And Bollinger Bands
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research

Everyone hates slow service. If your waiter or waitress doesn’t bring your meal on time, they get no tip. If FedEx delivers your package late, you don’t pay. And if a kid shows up at your doorstep on November 3 and yells “Trick or treat!” - they’re likely to be very disappointed that you ran out of candy three days ago.

Yet in the investment world, millions of people use technical analysis indicators every day that are slow, late and lagging… and think nothing of it. So let’s see if your favorite technical indicators are just rehashing history - or predicting the future.

And with yesterday being Halloween, the answer just might be frightening…

Lagging Technical Analysis Indicators: Staying Firmly “Behind” the Curve

In simple terms, lagging technical analysis indicators trail the price action of the instrument they’re tracking. The best example of a lagging technical indicator is a moving average or a moving average crossover system.

So take a look at the following chart, showing Google’s (Nasdaq: GOOG) performance this year, and let’s see what kind of lag we get with a standard crossover system using 20-day (the blue line) and 50-day (the red line) moving averages.

Standard crossover system using moving averages

In a traditional moving average crossover system, when the fast line (blue) crosses the slow line (red), you change the direction of your trade. As you can see, price lags of $40 to $90 per signal occurred on Google just this year alone!

This is the age-old problem with lagging technical analysis indicators - they give the signal long after the price has moved in your direction (sort of like the kid coming to your door for “Trick or Treat” in the middle of November).

So in order to execute a successful trade using lagging indicators, you need to see a really big trend. That way, even if you get in late, you still have some of the move left. The problem is that big trends happen infrequently.

For example, the chart shows that Google stock endured a huge down move at the beginning of the year, followed by a strong move back up from March to the end of April. Immediately afterwards, it moved down, and recently shares have climbed strongly again.

And amazingly, a trading system designed to catch parts of big moves only made money on the current move that is in progress because it took so long to recognize a trend and enter it.

Lagging Technical Analysis Indicators Hate Sideways Markets

The other big problem with trend-following technical analysis indicators is that they get chopped up in sideways markets. In the Google chart, you can see three crossovers between May and August, where the lag was so bad that you would have shorted near the bottom and bought near the top every time.

Of course, savvy analysts do many innovative things to reduce the lag. For example, they employ exponential or adaptive moving averages, and use shorter time periods. Or they add a third moving average to attempt to keep out of the market during sideways moves.

The bottom line is this: Lagging indicators work okay when the market is in big trends - whether it’s:

  • Moving averages,
  • ADX,
  • MACD crossovers

Take your pick.

But here’s the problem: Most studies show that markets are only in a trend 20% to 40% of the time! This means that in predominant market conditions, lagging indicators are pretty useless.

Fortunately, there’s a better way…

Leading Technical Analysis Indicators: Predicting Market Moves

Rather than reacting to previous price action, I like to act in advance. That’s why I like to watch leading technical analysis indicators. These tools seek to predict the time and price where a stock, futures contract or currency is most likely to change direction.

Widely used leading indicators include:

  • Oscillators like stochastics…
  • Relative Strength Index (RSI)…
  • And bands and envelopes.

These indicators tell us when the asset we’re following has most likely stretched too far in one direction.

So let’s look at the same Google chart… but with a simple Bollinger Band added.

Google chart with a simple Bollinger Band added

Break Out the Bollinger Bands

Simply put, Bollinger Bands show an upper and lower band, which is plotted a set number of standard deviations away from a moving average. Since standard deviation is a measure of volatility, this type of band adjusts itself to market conditions.

The usual way to apply this band is to anticipate that anytime the price closes outside of the band, it will move back inside the band, or regress toward the mean. Phew - that’s a lot of statistical mumbo-jumbo! So let’s look at a simpler explanation…

Another way to view Bollinger Bands is to think of the price as a rubber band: When the price stretches too far (outside of the bands), it’s likely to snap back, like an over-stretched rubber band.

On the chart, I plotted the number of occasions on which Google’s price moved outside the Bollinger Bands during the year. The signal in January was $20 early… but a very good shorting signal. In March, the predictive technical indicator nailed the low, and again forecast the high in April perfectly. And it predicted the June high within $10 dollars of the turn (not too bad for a $400 stock…)

Of course, no indicator is perfect. The stock saw only $30 of follow-through to the downside after the September high, and wouldn’t have made much money unless you got out quickly. And the October high was pre-mature.

With predictive technical analysis indicators, you have to have a full system in place to help you avoid calling tops and bottoms too soon. But a well-run system can catch short- and long-term gains with regularity.

Great trading,

D. R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • Easy trades happen for a reason - you just need the right system, or strategy to get you in at the right time. Back in an earlier Smart Profits issue, I explained how catching market moves is similar to riding the waves on the ocean - and gave three key trading lessons that you can learn from rising trades, falling trades, or flat trades. Check it out in Smart Profits #349, Trading Lessons: Catching The Market Waves for Stress-Free Trades.
  • My colleague and technical analysis compadre, Jim Stanton, emphasizes the importance of Dow Theory within chart pattern recognition and how this type of technical analysis can show what the market may have in store for the future in Smart Profits #362, Dow Theory: The Most Important And Powerful Concept In Technical Analysis.

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The Chart of the Week

Yahoo closing outside bollinger bands

Yahoo! (Nasdaq: YHOO) has shown a history of snapping back after closing outside of Bollinger Band. With a recent close outside of the band, look for a snap back to the downside.

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