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Investor Sentiment & Market Behavior
The Smart Profits Report: Issue #311
Tuesday, May 23, 2006
Investor Sentiment & Market Behavior: Seven Tips For A Profitable Downside Bias
By Steve McDonald
Advisory Panelist, Mt Vernon Research
It had to happen.
After a strong rally that saw the major indexes set multiyear highs, despite several distinctly negative conditions (geopolitical issues in Iraq, Iran and Nigeria, high gas prices, a falling dollar and a slowing housing market, among others), the run appears to be over for now.
Since the end of October 2005, the Dow alone has enjoyed a steady climb from around 10,200 to 11,125 at Monday’s close. But that’s a huge drop from a high of 11,709.09 as recently as May 10. The correction took longer than expected to occur, and the situation has given me an opportunity to think about investor sentiment and market behavior. One question that springs to mind is this:
“What is it about a drop of a few hundred points that makes investors dump positions as if the world is ending?”
Despite this frequent occurence, we always seem to react rashly, rather than act calmly. It’s because when it comes to the stock market, many of us possess an upside bias. This can cost us a lot of money, and also force us to miss out on big gains. So, here’s what we can do about it…
Making Money On the Ups And Downs
First, what’s an upside bias? It’s when you believe the market has to go up to make money. After all, it seems more natural to believe that something has to increase in value to make money.
But it’s actually harder to make money on the upside than on the downside - especially when you consider that the market is down two-thirds of the time. If you wait to profit during the upward swings, you’d better be very patient.
So, here are seven tips to help you develop an eye for the downside:
- No upside trend lasts forever, and every new high is an opportunity for a correction.
- Markets act in cycles, and most of the time they’re down.
- Good news means a stock will likely run too high and then correct.
- Let charts guide you. They show when a stock has run too far.
- Keep a log of when your positions rise and fall (you’ll have more downs than ups).
- If you find yourself marveling at how high a stock or a sector is, buy a put, or short it. Seven times out of 10, you’ll be right.
- The investing herd is rarely right.
The market gives you great tools for capitalizing on the downside. Here are two that are just as easy to use as buying a stock or a call…
PUTS: Calls are options that make money when the underlying stock goes up; puts make money when a stock goes down. You buy them the same way, and sell them the same way. They involve no more risk than a call and are priced similarly. They just make money more often.
SHORTS: Shorting is when you sell something you don’t own. You borrow a stock from someone you’ll never meet, sell it, buy it back low and return it when it goes down in price.
Watching Market Behavior & Using Puts
Here’s a great example of how puts can be so profitable. Take a look at the Energy Select SPDR (AMEX: XLE) two-year chart below. It’s made up of most of the big oil companies.
Pay particular attention to the volume on the lower part of the chart. Nobody wanted it at $30 or $35. But as this oil sector play steadily climbed, investors crawled out of the woodwork to buy it. And by the time it got to around $59, the whole world was in it!
While the chart looks impressive, it’s the perfect play for a put or a short, as you can see from the five-day chart below:
This is a ride many investors have taken too often. They wait for an investment to go up until they’re convinced it’s good. Then they ride it down.
Ignoring The Herd & Investor Sentiment
I recommended XLE puts about one week before the correction, and the volume tells me there were a lot of rookies out there who totally missed what was coming after the run it experienced.
As I said earlier, learn to ignore what the herd is doing, develop a critical eye, look for charts like the two-year for XLE and use puts and shorts to make money. Let the herd stay stuck in upside bias while you make money on their mistakes.
Good Trading,
Steve
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Today’s Smart Profits Cribsheet
- Fancy a quick 10% profit in three days? That’s exactly what subscribers to the Xcelerated Profits Report did by playing both the upside and downside of Tektronix (NYSE: TEK) in the most recent issue. Find out how you enjoy a whole year’s worth of profitable investment recommendations for about the same cost as filling your car with gas.
- As always, check out the Smart Profits Glossary for definitions of words like “put options” or “volume” found in today’s article as well as close to 200 other option terms.
- Make sure to take a look at Smart Profits #310, The Price of Oil, an article by all of our experts at Mt. Vernon Research and their take on where oil is going and what you can do to profit from it.
Related Articles:
- Short Selling: Beating the Government by Going Short
- Reading Volume to Find 20% Gains…in 20 Minutes
- Position Sizing: The Most Powerful Investment Concept
