Financial Figuring

Today we are going to look at several charts that are displaying the same pattern. Namely the “1st Thrust Down” pattern. This is a change in trend pattern (from Bull to Bear). There has been several of these patterns spotted recently and this is an indication of what the market as a whole might have in store for the near future. Lord knows the market can’t always go straight up.



Take a look at this first chart (courtesy of All About Trends, and used with permission) of Rovi Corp towards the end of Feb 2011. The notes on the chart are pretty self explanatory – but notice also the RSI during the ‘snap back rally’ doesn’t really climb. This was another signal that perhaps the bounce off the 50 day MA was not going to be sustained.


Now take a look at this second chart of Allegiant Travel Co. from the same time period. Once again during the snap back rally the RSI never breached 70 and was once again another signal of a change in trend from up to down.


Here is the third chart showing a ’1st Thrust Down’ pattern. This is Silicon Laboratories on Feb 23rd.


Lastly here is a look at VMWare from March 2nd. Notice the now familiar first thrust down, snap back rally (but fails to go to a new high and RSI hovers in the middle) then bombs away. When the stock breaks the snap back rally trend channel that is your sell signal (or you can buy puts for those who like to play options).


This chart also shows where the bomb dropped so to speak. Notice that the bounce occurred in the neighbourhood of the 200 day MA, and signals that it might now (or soon anyways) be a good time to go long. Naturally you will want confirmation from the S&P500 charts and Dow charts so that all are moving in the same direction, before making your purchase.

Using stock charts can provide a wealth of information about how a company is trading. Charts can provide hints of a coming rally or just the opposite is about to ensue. Combined with other buy and sell signals stock charting is a very useful tool.



Charting works because on a large scale human nature is predictable. Not individually of course, but when you are talking about large numbers of people – like everyone who is trading stocks. It is because people follow predictable trading patterns that there are certain chart patterns that can be worth a gold mine. (see my previous post)

These areas of a chart that coax people’s behaviour into buying or selling are often called lines of support and resistance. Don’t be fooled by the name however; they are zones, not hard and true lines. These zones are flexible. In fact, if you see a breach of short term support during an intraday move, you could be getting a signal of strong buyer support.

Take a look at the above chart of Winthrop Realty Trust, Inc. There are two patterns here to note.

First, look at the blue support line. Throughout most of October the price of FUR dropped below this line, but only intraday. Every time it dropped below the line there was strong buying that pushed it back before the end of the day’s trading. This is a terrific signal that buyers were willing to add to their positions during intraday weakness. Investors were unwilling to sell shares during these weak points. Another key point to note is that volume was strong when it finally did break out.

Secondly, we have a rising wedge pattern. This is very bullish and indicates that a strong rally may soon occur. Again look at the blue support line. Investors were buying the price dips and over time were not willing to let the price fall as far as the day before. The red resistance line indicates that there was reluctance on the part of buyers to pay higher prices. Again for most of October the maximum price investors were willing to pay was around $13. Eventually these two lines meet and the enthusiasm of buyers usually overpowers the reluctance of resistance.

It is a good idea to wait for the market to close before pulling the trigger on your trade. Volume is used to confirm a move in one direction or another. If you had been scared off by the intraday moves below the blue support line you would have missed a lovely break out above the red resistance line.

I seem to be a little early when I’m trying to call a market top. Like 2 weeks early, and during those 2 weeks my positions are underwater. And I get nervous. Then the market reverses and I’m back in the black. This happened all summer long. I’m kicking myself to hold off making trades since I’m always a little early.



Back in April of this year (2010) the S&P 500 had made a huge run off the February lows, but by the middle of that month I had figured that that was enough and I started buying puts. (Recall that if you buy puts you are hoping for stock prices to fall so that your puts will profit). What happened? Well the S&P 500 kept rising and my puts kept falling in price.

Finally the first week in May occurred and prices crashed in a hurry and I made some very nice profits. But they could have been so very much better.

Again in June I was sure the market was going to drop once again. Once again I started buying puts and once again the market kept rising. Finally, the end of June came along and ravaged stock prices even worse than in May. I realized some profits, but once again it could have been so much better.

Additionally, several of my puts expired in June and the move didn’t occur until after options expiration day. My puts were worthless, even though I had been correct on the direction of the move (in stock price). How frustrating – I was right but I still lost money. This is why most people are scared of options.

What about right now (middle of September 2010)? I feel very certain that we are due for a pull back. Many of the leading stocks are over extended. Most are at or above the top line in the Bollinger Bands. All are way over their 50 day moving averages and hitting resistance levels. October is coming and that has been traditionally a bad month for stock prices.

I started buying puts late last week – and once again the market keeps rising. I had a few September puts that will expire nearly worthless tomorrow, but most of my puts come due in October.

The smart thing to do is to establish small short positions and slowly leg into new positions. This lowers your per unit cost (if you are buying puts and the market still rises) and allows you to fill out your position. As this market extends even further the technical indicators are screaming for a reversal. When it comes it will be swift and steep.

A swift downside move is coming. If you’re chasing stocks higher you’re likely to regret it in the days ahead.

Be careful. Plan your trade and trade your plan

In 2001, gold traded as low as $255 an ounce. Within eight years, its price had quadrupled to more than $1,200 an ounce. Not only that but since hitting its bottom back in 2001, gold has posted a positive return in every calendar year. The current bull market has been pretty steady.

During the past 10 years, gold has become the trade we all wish we had made, beating out commodities, oil, high-grade U.S. corporate bonds, U.S. Treasuries, and even U.S. stocks.



A crisp $100 bill invested 10 years ago would today be worth more than $400 in gold, $357 in commodities (as measured by the GS connect S&P enhanced commodity total return strategy), $268 in oil, $190 in corporate bonds or U.S. Treasuries, and only $90 in U.S. stocks.

That’s not a misprint, that’s a $10 loss in U.S. stocks over 10 years. Ouch! Of course 10 years ago the Dot.com extravaganza was about to bust, so valuations were sky high.

Clearly gold has been a very, very good performer over the last 10 years. So how can we capitalize on this massive move and will it continue?

The trick is to avoid buying gold stocks when they’re running higher and when everyone else is rushing into the sector. You want to buy into the sector when the stocks are oversold and everyone else is jumping out of them.

The strategy? Just follow the single best gold stock timing indicator in the world: the gold stock sector’s bullish percent index (BPI). Remember that a BPI is a momentum-based indicator that measures overbought and oversold conditions. It shows us when gold stocks may be ready to snap back in direction, both up and down.

Most sectors are overbought when the bullish percent index rises above 80. This is a warning sign the upside move is stretched and may need a pause. Stocks are oversold when the BPI drops below 30. And especially if it drops below 20. This usually occurs near the end of a downside move.

Oversold and overbought conditions are not, by themselves, reasons to buy or sell stocks. Oversold conditions can get more oversold just as overbought conditions can get even more overbought. Trading signals occur when the BPI reaches an extreme level, and then starts to move back in the other direction, when a sector’s extreme move has lost its momentum. For gold, a good indicator is when it drops below 30 (or especially 20) then reverses and crosses its 8-day moving average.

These extreme “buy gold stock” readings don’t flash often. The last signal was in February of 2010 (not that long ago).



As you can see, gold stocks haven’t been below 30 (oversold) since late 2008, when it briefly reached 0 in early December ‘08. This was an extraordinary time to buy gold stocks. Just after the extreme reading back then, the big gold miners ETF (symbol GDX) doubled in price in four months, and went from around $18 back then to $49 today. Take a look at what happened in GDX since Feb 2010. A rise from $40 to $49 which is a 22.5% profit in just 2 and a half months.



As to the question of can the price of gold continue its amazing run, let’s consider some numbers from the past just for fun. Can you remember the energy crisis back in the early 70s? This started a huge bull run for gold too. Back then gold peaked at $850 in 1980. Ok back to some fun numbers.

To start with, let’s take the 1980 peak price of gold – $850 – and adjust it for inflation. That would take the price of gold to $2,400 in present-day terms.

Better still, let’s take the 2,400% gain that gold experienced during the 1970s and translate it into present-day terms. From the 2001 low of $255 an ounce, a 2,400% gain would take the precious yellow metal all the way up to $6,120 an ounce.

Of course these are pretty superficial numbers – after all who knows if gold will experience another run like it did during the 1970s. History does tend to repeat however.

On the serious side here are some fundamental reasons that gold should continue its bull run.

1) US inflation will have to soar. The government’s quantitative easing to shorten the recession has caused the US monetary base to explode. Starting in October 2008, during a very short span of only four months, the central bank doubled the money supply. Looking back at economics 101 if you double the supply the demand will drop. Essentially the value of each dollar will drop (inflation). Since gold is measured in US dollars, and if each dollar is worth less, it follows that each ounce of gold will be worth more US dollars.

2) Large institutional investors – hedge funds and pension funds – are making large allocations to gold, as are individual investors.

The proliferation of gold-focused exchange-traded funds (ETFs) bears this out. The SPDR Gold Trust (NYSE: GLD), the world’s largest physically backed ETF with 1,100 tons of the lustrous metal, is the sixth-largest holder of gold bullion. Individual investors have never had an easier avenue for owning gold.

According to the World Gold Council, demand advanced 15% from the second quarter to the third last year. Asia, with a population that exceeds 2.5 billion inhabitants and a long-standing cultural affinity for gold, is stoking global demand in a big way. China is overtly encouraging its citizens to buy gold and silver, while offering them gold-linked checking accounts. China is primed to overtake India as the world’s largest consumer of gold. A quickly developing middle class whose members are experiencing rapid escalations in disposable income are a major bullish driver for the price of gold.

3) National central banks are becoming buyers of gold instead of sellers. India’s recent purchase of 200 tons of IMF gold was the likely impetus that pushed gold up over the $1,200 level in December 2009. BlackRock Inc., one of the world’s largest investment managers, said that 2009 was a turning point. If this is correct, it will have been the first time in 20 years, as central banks have been net sellers of gold since 1988.

4) A currency crisis is looming. The “PIIGS” – Portugal, Italy, Ireland, Greece and Spain aren’t in very good fiscal shape. And they aren’t alone. Iceland has already gone over the edge. The United States, the United Kingdom, and countless other economies are struggling. And that reality has ignited a crisis of confidence in the minds of many investors. Money is nothing more than paper and ink, backed by the “full faith and credit” of the issuer. When investors find that their faith in the issuer is shaken, the value of that currency erodes. Greece’s bonds were just downgraded to Junk status yesterday, triggering a sell off in the world markets, and a flight to safety. If the other PIIGS or other economies suffer a downgrade, gold – the ultimate store of value, and the oldest existing form of money on earth – will soar as investors seek to protect their purchasing power.

5) Gold while popular has not hit a manic buying stage yet. When this happens the price of gold will be all over the media. Think back to the dot.com craze of 1999, it will be in every magazine, e-zine, newspaper and television (radio too for those older folks). It will also be all the talk at water-coolers. You’ll be getting tips to buy gold from your grandmother, and the plumber too.

The massive run up will start with currency devaluations, and will be fueled by growing investment demand. Its stratospheric ascent will be the mania phase of this evolution.

The price of gold will behave like it is strapped to a jet pack. And today’s market prices will be dwarfed by the levels gold prices will ultimately achieve.

Keep in mind, the entire gold industry has an aggregate market capitalization (value) below that of Wal-Mart alone (currently about $210 billion). So as the crowd piles in, the “big money” to be made will lie with gold explorers and producers, where 1,000% returns will not be uncommon, even from today’s prices.

If you already own gold hang onto it. If you don’t yet have any gold follow the overbought/oversold gold stock readings, you’ll do far better in gold stocks than most folks ever will. You’re either a contrarian with these stocks… or you’re giving your money to those of us who are.

Can this incredible bull market continue? That is the question I have been asking myself for the past month. Since the market lows of March 2009 the DOW as been almost new high after new high. Some of the technical indicators are finally showing that a reversal is coming and we are due for a correction.



Bullish Percent Index (BPI) measures the percentage of stocks in a sector or index (in this case the Dow Jones Industrial Average) trading with bullish “point and figure” chart patterns. It’s best used as a measure of overbought and oversold conditions. Take a look at the following chart of BPI:

BPI on the Dow hit a record low of 0 in early October 2008. It was below 9 in late February and early March of 2009, which was the low point in the market as the DOW hit 6500. There has been a steady rise since then to a record high yesterday closing just under 97. This corresponds with a rise in the DOW as well to over 11000. (A rise of approximately 70% in just over a year, which is remarkable)

The standard thresholds for BPI are 80 and 30. Meaning that if BPI is below 30 it means less than 30% of the stocks in the index are trading in a bullish pattern. That’s an oversold situation and suggests the index or sector is vulnerable to a bounce.

Conversely, when a BPI rises above 80, it indicates an overbought situation and suggests the sector or index may be poised to correct. As mentioned above, yesterday it closed just under 97, which means that 97% of the stocks in the DJIA have a bullish pattern in their charts. It almost mathematically can’t get more bullish than that.

An overbought condition by itself isn’t enough to trigger a short sell for the index. Overbought conditions can get more overbought just as oversold conditions can get more oversold. However when a bullish percent index reaches an extreme condition and then reverses, it often provides the catalyst for a good trading opportunity. The key to watch here is the 20 day moving average (currently at 90). If the BPI reverses and drops below the 20 day MA that would be a signal to act upon.

Now combine the BPI with what we learned the other day with the VIX.

The VIX as you may recall is a measure of the amount of volatility in the stock market, based on the number of put and call options that are traded on S&P 500 shares. Essentially as the VIX rises (increased volatility) investors are betting that the market will drop. When the VIX falls investors are complacent and betting that the market will rise. Take a look at the following chart for the VIX for the past 18 months.



Investors were very, very scared in November of 2008 when the S&P500 index hit a low of about 750 the VIX peaked at over 85. Now the S&P500 got worse in March of 2009 dropping below 700, but investors were slightly less fearful as the VIX hovered around the 50-55 level.

Recall our rule of thumb that states:
• When the VIX is between 10 and 15: Sell stocks.
• When the VIX is over 40: Buy stocks.
• When the VIX is over 50: Buy more stocks.
• When the VIX is between 60 and 70: Take out a second mortgage and load up.

As you can see according to our rule with a VIX at 85 in late 2008 was a time to really load up on stocks. But so too was March 2009 with the VIX above 50. You might have been quite nervous from November 2008 to April 2009 but from then onwards you would have been laughing all the way to the bank.

Now let’s look at today on the VIX. With a reading of just over 15 what does that tell us? It is extremely close to time to sell your stocks.



In summary then the BPI is telling us that a reversal is imminent (but not here just yet) and the VIX is also indicating that we should be ready to sell. Can the market continue its climb? Of course, but right now the market is irrationally high and a correction is looming. Just remember the famous saying around Wall Street: “The market can stay irrational longer than you can stay solvent”. Keep an eye on your indicators and set your stop loss orders very tight so you can maximize the profits on this remarkable Bull Run.

The Relative Strength Index, or RSI, is a momentum indicator that depicts the price momentum of the stock you are trading.

Introduced by J. Welles Wilder Jr. in his 1978 classic, New Concepts in Technical Trading Systems RSI is one of the best known of all technical indicators. Essentially RSI shows the ratio of price movement on days the stock price rises as compared with price changes on days the stock price falls. It then normalizes these gains by forcing the index to hold between a level of “0″ and “100.”



The formula used to calculate RSI is as follows:

RSI = 100 – [100/(1+RS)]

Where,

RS = Average of up day’s closes / Average of down day’s closes

This average is determined by summing up the total price gains on up days and dividing by how many total price changes you are examining. For the down average, add up the absolute value of the changes on the days prices fell, and then divide that figure by the total number of price changes.

For example, if I compute RSI using 11 days of prices, I will then have 10 price changes. If the sum of the gains on the up days is $1.50 and the sum of the losses on the down days is $1.00, then the RSI calculation would look something like this:

Average of up prices = $1.50/10 = 0.15
Average of down prices = $1.00/10 = 0.10

RS = .15/.10 = 1.5

RSI = 100 – [100/(1+1.5)] = 60

OVERBOUGHT AND OVERSOLD

RSI is often used as a way of determining when something is overbought or oversold. The term “overbought” is supposed to mean that the stock you are tracking is at risk of reversing lower, at least for a correction, because its price has risen too far, too fast. Meanwhile, “oversold” stocks are supposedly in position to reverse higher because their prices have fallen too far, too fast.

RSI offers you one way of quantifying overbought and oversold. When I’m using a 14-day RSI, then I generally consider the 70 level to be overbought and the 30 level to be oversold. If I use an 8-day measure, then I would use 75 or 80 for overbought and 20 or 25 for oversold, as the smaller the number of days, the more volatile the RSI indicator will be.



Keep in mind that these “rules of thumb” will probably get you into a whole lot of trouble. RSI is what is known as a “momentum oscillator.” If you attempt to use the indicator to sell when momentum is high or buy when it is low, you may very well be trading against the trend. By definition, the market will tend to be overbought in a strong uptrend and oversold in a strong downtrend. Buying and selling at oversold and overbought levels works only in a range bound or non-directional market.

Some traders will still try to sell when RSI gets high or buy when it is very low. However, they will adjust for the market’s overall trend. For example, if the trend is up, then many traders will only sell when RSI moves above, then falls below, the 80 mark. If the trend is up, they will buy if RSI falls below and then moves back above 40. Likewise, in a bear market (read trending down), they will often buy only when RSI drops below and then moves back above 20 and will sell on a move above, and then back below, 60. (Note: All of these levels are based on a 14-day RSI measure.) Personally I find that RSI is better if used to assist in making a sell decision and not so much on a buy decision. When RSI falls below 70 (or 80 in bull market) then I think this is one sell signal, which I would act on only if confirmed by other indicators (full stochastic, MACD, volume analysis, trend line analysis, etc).

Another great use for RSI is when a divergence occurs. Divergences are often a warning of an impending change in trend. For example if the stock you’re examining is in an uptrend, then a divergence occurs when prices reach a new high, but RSI does not. If the stock you’re examining is in a downtrend, then a divergence occurs if prices fall to a new low, but RSI does not manage a new low. When this occurs it is warning you that a trend reversal may be immanent.



In the example above notice how the stock price is reaching new highs yet the RSI is not following suite. This is called negative divergence. Of course only time will tell if the stock will reverse, but based on this indicator it certainly looks like a drop in price is coming. The next step would be to confirm your ideas with other indicators.

A word of warning: RSI is only one of several indicators that should be examined. You should not base your buying and selling decision on only one indicator. Wait until at least two and preferably three different indicators give you the same signal before acting.

SUMMARY

The Relative Strength Index (RSI) is one of the most widely used technical indicators. It is well suited as part of a computer-based trading system. However, blindly following the crowd by selling when the market is overbought, or buying when it is oversold, is a strategy that is nearly guaranteed to lose you money in the long run.

Most economists will tell you that stock prices are determined by supply and demand and that free markets, being efficient, will always yield the correct price or value for a company. However there are instances where the market is NOT efficient and fluctuations in price can vary, in some cases wildly. This is why speculators buy and sell hoping to take advantage of the price swings.



One method of measuring these inefficiencies is through the number of put and call options that are traded on the S&P 500 shares. This is a measure of the volatility of the market. If you’re not familiar with the Chicago Board Options Exchange Volatility Index don’t feel bad. Many people don’t understand what it means or how you should act upon its moves.

Put simply, when investors are betting on the market going higher, the VIX responds by heading lower. When investors are taking the market down, the VIX moves higher. This is why it is sometimes referred to as the “fear index” because when investors are fearful this index rises. And of course, the reverse is true when investors are complacent (or greedy).

So we have just had a very nice (and long) run up in the markets. Where would you think that the VIX stands? Well, it started in 2010 with a string of down days – all the way down to a 19-month low today, in fact. (It’s currently trading around 16 points, which isn’t historically low, but low enough to indicate complacency among investors.)

Which is exactly when I start to get nervous. When complacency reigns, the market has a way of getting everyone’s attention again (i.e. – a turnaround is imminent).

And when the market turns, the VIX blasts to the moon quickly, usually much faster than it falls. (This tells us that investor fear is stronger than investor greed).

So here’s the rule of thumb:

• When the VIX is between 10 and 15: Sell stocks.
• When the VIX is over 40: Buy stocks.
• When the VIX is over 50: Buy more stocks.
• When the VIX is between 60 and 70: Take out a second mortgage and load up.

Again, the VIX sits at around 16 right now – very close to a sell signal, which is why I suggest you pay close attention (and adhere) to your sell stops.