Changing the Rules

Laws pretty much work the same way all the time. The intent of a ‘come to a complete stop' red-light law, and the repercussions of running a red light, are the same in 2013 as they were in 1963.

Rules, especially trading rules, are another matter. You've invested quite a bit learning to become a master trader. All those seminars. All those books you bought. Larry McMillian's ‘Options as a Strategic Investment' alone weighs 3-3/4 pounds, takes up 2-1/8 inches of bookshelf, cost $65 in 2002, and over several days you got through only 2-1/2 chapters (there were 42 chapters and 5 Appendices, a Preface, a Postscript, and a Glossary in total).

982 pages of rules for analyzing and trading options. And are you now a master option trader? Do you have your own segment on CNBC? Do the Najarian brothers call you for advice? Do option ‘groupies' hang outside your front door waiting for you to come out and grace them with today's trade (much to the dismay of your wife and the neighbors)?

No? What went wrong?

The difficulty here is we are not dealing with an immutable environment. We learn a trading rule from a book, seminar, or the school of hard knocks, and guess what – it doesn't always work. Sooner or later, the aspiring Master Trader learns that trading rules need to be constantly analyzed for relevance to current conditions.

My rant, I mean focus, today is on the topic of short trades. We all know there are times in every stock where the higher probability trade is on the downside, a bet that XYZ stock will fall. In a way, analyzing a good short trade is just a mirror reflection of analyzing a good long trade. A decline in fundamentals, a breakout (to the downside) of a trading range or channel, and a strong reversal to the downside are all good patterns to identify and trade bearishly upon, mainly by shorting the stock or entering a bearishly-oriented option trade.

If the company had improving fundamentals, if it broke upwards out of a trading range or channel, or reversed to the upside, the majority of professionals would likely agree it would be a good time to buy the stock (‘take a long position').

But does it work the same way on the downside? Sometimes it does and sometimes it doesn't.

In mid-April of 2011, US Steel (X) was pulling back. Volume on down-close days was starting to be above average and greater than volume on up-close days. X pulled back to the area of previous support at January's pivot low of 51. X finally broke below support, which likely caught the attention of many institutional traders.

X briefly penetrated the 200-day moving average but rebounded on a spurt of buying. That didn't last long, and in the last week of April the stock sold off sharply, again penetrating the 200-day MA on very high volume. This was one of the classic short signals, a textbook case of when to short a stock.

X sold off steadily into early October, producing a maximum gain of 61% for anyone shorting the stock (most likely the actual gain was much higher as shorting usually involves margin).

Switch to Atwood Oceanics (ATW) in October of 2013. ATW tested support at 54 several times and finally broke below it in late October. ATW penetrated the 200-day MA on increasing volume. Recent volume on down-close days was overwhelming volume on up-close days. Finally, in late October, ATW briefly rebounded but quickly broke down and thrust through the 200-day MA on high volume.

Entering a short position at the open of 53.01 on November 1st, on a gap-down with high volume in the first 30 minutes of trading, had to again be a textbook short trade.

You would think so, but the next day ATW gapped-up on the open and over the next 10 days it gained 11.7%.

Atwood was one of two stocks I was watching in late October, getting ready to point out to readers of Seasonal Forecaster a good short opportunity.

At the time, ATW had a ‘seasonal', a track record of declines in the stock over the next several weeks. For example, ATW had lost an average 3.3% over the next two weeks, with losses (or at least no gains) in 21 out of 29 years. There was a pretty good case for a short trade in ATW.

But I held off. I didn't mention it to readers. Good thing because the 11.7% gain over the next 10 days would have triggered a stop-loss.

Why did I not mention the possible short trade to readers? Because I had recently come to the conclusion that some rules didn't apply anymore, especially the ones for identifying high probability short trades.

In recent months, I had covered a few short trades in the newsletter, and ‘paper traded' a few others. Only about half were working out. Normally good breakouts to the downside were quickly failing in many stocks. There was (and still remains) too much buying power in the stock market.

It of course is not an unusual event late each year as institutions fine tune their portfolios and search for the stocks of good companies that have pulled back and represent a value purchase. But 2013's stock market has shown consistent steady buying, even through a possible war and a government shutdown. Where has that buying been coming from?

Most likely it is the effect of the Fed's bond buying program, affectionately known as Quantitative easing (QE). Why would bond buying boost the stock market? As older bonds reach maturity, the Fed is buying them. Institutions that held the bonds would normally buy new bonds. But the supply is being soaked up by the Fed, and the process itself has caused interest rates to sit at rock bottom lows. Compared to the risk, it's just not worth holding a bond anymore. What to do with that money? The ever-rising stock market.

Even the former manager of the Fed's QE program came out recently and actually apologized to America for participating in the effort. His article was published in both the Wall Street Journal and at Zero Hedge (read it here). He begins by saying..

“We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street.

I can only say: I'm sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed's first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I've come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.”

The lack of normally good short trades following through, coupled with the knowledge the Fed continues to pump $85 billion a month into a program where much of it goes into the market, told me I had to throw some old rules out the window. Someday they will become valid again. It's just too risky to keep them in my trading toolbox right now. There will always be trading rules that fall into this category. Successful traders continuously question the rules and make sure they are appropriate for the current market environment.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, type in www.markettamer.com/seasonal-forecaster

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2013 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

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