Now that the stormy waters have calmed for the summer, I had a few requests to do a middle of the year “2014 review.” We’ll plan on doing this live on Tuesday, June 24th, but I also wanted to hit a few things as to what had happened to the market this year, and why we didn’t see it coming until a few months in.
Every year or two, financial markets absorb some sort of shock. Whether it be headline risk, geopolitical risk, an unknown or unanticipated event, or any such substance that causes investors to panic. Once panic sets into the market it causes investors to behave in an erratic manner, and throws the option market into disarray. This major shift earlier in the year, out of growth stocks and into value stocks was an event that I’ve compared against the second half of 2011, post flash crash/summer 2010, the Global sell-off in 06, and many other fear driven environments. You’ve followed me long enough to know that market direction up or down does not dictate our profitability in normal market conditions. We’ve gone net-long leveraged with several front month otm call options into weeks of market weakness and came out just fine. In fact, we’re usually the belligerent assholes around here making money net long on down days acting a fool. However, there is a distinct difference between orderly market weakness (fluctuation) and fear driven selling that needs to be recognized early in order to avoid situations like we saw earlier in the year. You need to know the difference between them so you know when to hold through orderly pullbacks and when to just cash out altogether. Chess did a great job of this early on, while others like myself kept pumping quarters into the machine and not taking notice to warning signs that were discretely saying caution ahead.
Trading has a lot of similarities to sports; but golfing in particular. Most good golfers will gauge many outside influences before they strike a ball. Most novice investors just step up to the tee and try to smack the ball down the fairway. This is why most novice investors have a short shelf life. A good golfer focuses on stance, swing, grip, ball lie, wind, and many other factors before taking a swing. As a trader, I do the same and attempt to teach this craft everyday during After Hours with Option Addict. As a trader, you can’t just sit down to the computer and think “its a great day to buy XYZ.” You have to survey the pulse of the market, understand the markets tolerance for risk, understand its appetite, and anticipate where it will move to next.
As a trader, I rely on several indicators to help me gauge my environment. I specifically look for speed, volatility, and what stocks are being bought each day. I focus on correlations, I watch hundreds of stocks, and rely heavily on relative strength: index to index, sector to sector, and stock to stock. This is why every day we have multiple holdings making the “top percent gainers” columns. All of this analysis combined is required to understand where the market will move next.
However, as I mentioned earlier, every year or so the market will absorb some sort of shock, or fear induced event that sends it into disarray. When this happens, the markets get fast. When markets get fast, stock behave in an erratic manner. When stocks behave this way, option premiums explode, and when option premiums explode, it becomes difficult to swing trade, unless you take quick shots on either side of the market. Those environments are phenomenal for day trading, but miserable for swing trading. The opposite is true about these slow grinding conditions we have now. Miserable to day trade, awesome to swing trade.
Any good trader will use a series of indicators to gauge his environment, as do I. To know when to back off option buying, I use the VIX. To know when to ease off swing trading and transition to day trading, I use an ATR. The reason I missed the complexity of the environment this year, is that I normally apply these indicators to the S&P. As you all know, the S&P went unscathed this year, while the Russell and Nasdaq were hit the hardest.
A few readers mentioned in the comments yesterday how they could recall my words at the beginning of May that our “fat pitch” was coming within weeks, and that we would return to a normal trading environment. This has been spot on, and our application of sentiment cycles to markets and individual stocks has helped mend fears that came as a result of a few months of difficult conditions at the start of the year.
We’ll review this in detail next week on video. I’ll provide you the tools needed to understand your environment at all times, in hopes of helping you line the best shot you can hit next time you step up to take a swing.
OA
Comments »
