What I’m Observing in Stock Indices

Right Now:

DJIA: At an all-time high

S&P500: At an all-time high

NASDAQ 100: Just below the all time highs of 2000 and late-2015

RUSSELL 2000: Just below the all time high of mid-2015   

I believe that the probability of stocks continuing to move higher increases if the NASDAQ 100 and Russell 2000 break past their all-time highs. The technical move in stocks is ‘confirmed’ if all the major indices surpass their all-time highs.

This also means that if the NASDAQ 100 and Russell 2000 can’t push through their highs, it will be difficult for stocks to keep this recent move going.

Historically:

Markets become increasingly susceptible to bubbles when interest rates are low and money supply is high. This is the environment we are currently in. Historically and intuitively, we are in for an eventual big correction in stocks due to monetary policy. But as long as interest rates hug 0%, we could be in for higher prices in stocks for some time. There is no saying where the top is.

 

My preference is to follow what the aggregate voice of the marketplace is telling me. My core strategy is to buy strength and sell weakness. This puts me in position to capture the big moves in markets. While I acknowledge the fundamentals of stocks, I’m not one for calling tops and bottoms. I’ll let the market do that for me.

 

Anytime I think that interest rates will stay at 0% forever, and that prices are going to the moon, I’ll come back to this quote:

"But I think our ace in the hole is that governments usually screw things up and don't maintain their sound money and policy coordination. And about the time we're ready to give up on what has worked, and proclaim that the world has now changed, the governments help us out by creating unwise policy that helps produce dislocations and trends."

-Jerry Parker

Crude and Stocks

The correlation between stocks and Crude Oil has been strong.

I think the correlation may be due to bank exposure to oil debt--The lower oil goes, the greater the probability of oil companies defaulting on their debt.    

While stocks have been moving higher lately, oil has moved lower. I think this price divergence is worth noting.  

There is no saying where oil goes from here, but if the prices continue to move lower, stocks may follow.   

Based on recent price data, I have a hard time believing in a reality where oil moves back down to $40 and stock indices stay strong. But, then again, anything can happen in markets.

Post-Brexit

Last week I posted a chart of the DJIA post-“Brexit.” Here’s where the DJIA was:

Here’s where the DJIA is now:

This was one of the wildest weeks I’ve ever seen in the market. I could not have imagined the DJIA could move so fast in both directions in only five trading days. The “V” move up from 17000 was remarkable.

If the DJIA fails to break above 18,000 in the next few weeks, I expect the stock market to move erratically in the search for price discovery and thus for volatility to increase.

With increased volatility comes more expensive option premiums.  

You can’t buy insurance when the house is already on fire.

--

When the VIX, the CBOE volatility index, spiked up last Monday, gold and silver surged higher, as did the $USD in relation to the falling British Pound and global stock markets.  

The big moves up in gold and silver are telling in relation to the current market environment. Gold and silver continued their move upward as the $USD and the VIX dramatically fell while the stock indices recovered throughout last week.

Either gold and silver are foreshadowing more future volatility, or gold and silver are set for a big move lower.

Both scenarios are realistic, but in light of inflated currencies worldwide courtesy of low interest rates+QE, and a plummeting British Pound, its seems prudent to bet on volatility catching up to gold and silver’s price action, not the metals moving down.

***It's impossible to know if any of these trends will continue, but building low-risk, high-reward trading ideas around a general thesis with confirming price movements is an approach I subscribe to.  

Brexit Aftermath

I don't try to predict what markets will do. I live in the world of risk/reward paradigm.

I follow markets and place bets when I see favorable situations. To me, a favorable situation is one where I can bet a little and make a lot.   

It's not really the market ‘set-ups’ that make me money. The main driver is the respect for risk--which, in the long run, creates a market edge when applied to the ‘set-ups.’

Regardless of what direction I’m betting on, my market positions will reflect an aversion for large losses and an optimistic outlook on large returns.   

In my observation, the main stock market indices(DJIA, S&P500, NASDAQ) are moving to the downside.

From a technical view, there is essentially nothing stopping the DJIA from revisiting the August and January lows. There is a potential price vacuum from DJIA 17,000 to 16,000--I believe it's the path of least resistance.

And this 1000-point move can happen in short order.  

This is the main opportunity--DJIA 1000 points to the downside.

But this opportunity alone is useless if I can’t get a good ‘set-up’ and a good deal playing it.

If I’m wrong, and the DJIA shoots right back to 18,000, I don't want to lose much.   

I don’t like to bet directly on the indices.

I like to use the them as a weathervane. Once I have a general idea of the direction I want to bet on, I identify sectors that I believe are headed lower. Within the sectors, I’ll select the individual stocks that present the very best opportunity.

In this situation, I want to exploit a market downside by buying out-of-the-money puts. Namely on stocks that are currently moving in a downward direction, have trading volume of 1,000,000+(liquidity), and provide a disproportionately favorable risk/reward paradigm(cheap contract prices relative to a stock’s potential price discovery).

I will likely be wrong on most of my trades. But I want the potential to get 10X, 20X, and 30X my money on some of my trades. Simultaneously, I want to keep my exposure to the market small relative to my assets in my portfolio.   

The options market is tough. It took me a few years to really get the basics. You can only learn by doing--no amount of explanation will truly prepare you.  

There is opportunity for those who know where to look and how to respect risk. 30-to-1 payouts exist in markets. These payouts go to those who are prepared for them. If you do not believe that you can capture wins of this magnitude, your market decision will reflect that belief, and the right habits will never develop. In this sense, we all create our own destiny in markets.   

Trading in markets is a personal journey. But once the foundation is formed, you can take ideas from everywhere and process them through your system.   

Brexit Aftermath

I don't try to predict what markets will do. I live in the world of risk/reward paradigm.

I follow markets and place bets when I see favorable situations. To me, a favorable situation is one where I can bet a little and make a lot.   

It's not really the market ‘set-ups’ that make me money. The main driver is the respect for risk--which, in the long run, creates a market edge when applied to the ‘set-ups.’

Regardless of what direction I’m betting on, my market positions will reflect an aversion for large losses and an optimistic outlook on large returns.   

In my observation, the main stock market indices(DJIA, S&P500, NASDAQ) are moving to the downside.

From a technical view, there is essentially nothing stopping the DJIA from revisiting the August and January lows. There is a potential price vacuum from DJIA 17,000 to 16,000--I believe it's the path of least resistance.

And this 1000-point move can happen in short order.  

This is the main opportunity--DJIA 1000 points to the downside.

But this opportunity alone is useless if I can’t get a good ‘set-up’ and a good deal playing it.

If I’m wrong, and the DJIA shoots right back to 18,000, I don't want to lose much.   

I don’t like to bet directly on the indices.

I like to use the them as a weathervane. Once I have a general idea of the direction I want to bet on, I identify sectors that I believe are headed lower. Within the sectors, I’ll select the individual stocks that present the very best opportunity.

In this situation, I want to exploit a market downside by buying out-of-the-money puts. Namely on stocks that are currently moving in a downward direction, have trading volume of 1,000,000+(liquidity), and provide a disproportionately favorable risk/reward paradigm(cheap contract prices relative to a stock’s potential price discovery).

I will likely be wrong on most of my trades. But I want the potential to get 10X, 20X, and 30X my money on some of my trades. Simultaneously, I want to keep my exposure to the market small relative to my assets in my portfolio.   

The options market is tough. It took me a few years to really get the basics. You can only learn by doing--no amount of explanation will truly prepare you.  

There is opportunity for those who know where to look and how to respect risk. 30-to-1 payouts exist in markets. These payouts go to those who are prepared for them. If you do not believe that you can capture wins of this magnitude, your market decision will reflect that belief, and the right habits will never develop. In this sense, we all create our own destiny in markets.   

Trading in markets is a personal journey. But once the foundation is formed, you can take ideas from everywhere and process them through your system.   

Ray Dalio and The Economic Machine

Below is a link to an animated YouTube video of Ray Dalio explaining his belief about markets. The guy is worth about $15 Billion and he runs a $150 Billion hedge fund. He seems to be generous with his thoughts as the video is super informative.

How the Economic Machine Works

Fear of the Markets

In Jack Schwager’s Market Wizards, a common theme amongst traders is a genuine fear of the markets. I’ve chosen two quotes from the book that I believe best exemplify how market fear fuels trading philosophy.

1: “I am more scared now than I was at any point since I began trading, because I recognize how ephemeral success can be in this business. I know that to be successful, I have to be frightened. My biggest hits have always come after I have had a great period and start to think that I knew something.”

-Paul Tudor Jones

2: “I have found that the greatest traders are the ones who are most afraid of the markets. My fear of the markets has forced me to hone my timing with great precision. When I am trading properly, it is like a pool player running racks. If my gut feel of market conditions is not right, I don’t trade. My timing is a combination of experience and my nervous system. If my nervous system tells me to get out of the position, it is because the market action triggers something in my knowledge and experience that I have seen before.

I also don’t lose much on my trades, because I wait for the exact right moment. Most people will not wait for the environment to tip itself off. They will walk into the forest when it is still dark, while I wait until it gets light. Although the cheetah is the fastest animal in the world and can catch any animal on the plains, it will wait until it is absolutely sure it can catch its prey. It may hide in the bush for a week, waiting for just the right moment. It will wait for a baby antelope, and not just any baby antelope, but preferably one that is also sick or lame. Only then, when there is no chance it can lose its prey, does it attack. That, to me, is the epitome of professional trading.”

-Mark Weinstein

Avoid This Basic Mistake…

When I look back on all my biggest losing trades from past years, I either risked way too much on an initial buy, averaged my losers, or didn't plan an exit before an entry...or worse, did all three together.

Baby Steps Toward Success:

Planning for an exit before an entry will save your butt.

Shown below are some stocks that could have hurt investors/traders in the past years. However, with prudent initial risk, and a predetermined exit, participants would have side-stepped disaster.    

While trading individual stocks, I believe there is no need to let falling prices unnecessarily corrode capital. I'd prefer to exit a position with a small loss than a huge loss.

Novice players often say to themselves: “I’ll sell when it gets back to even.” Even may never come. Or worse--they will buy more stock as prices go down, because if it was good at $70, it has to be great at $50, and even better at $30--😬 Quick path to large losses.

Now the important question is, “How do I determine my exit strategy before I buy?” If you are pondering this question, you are on the right path.

An Approach to Options

In my trading process, it's never about one trade, it's about the system. The paradox is that ~90% of profits come ~5% of trades, so it's imperative to create an environment that can catch big moves, while keeping losses contained. I have no way of knowing where the next big trade is, so my basic philosophy is to de-emphasize any one particular trade. This is done through placing small ~equal amounts of risk as a % of my portfolio per trade.

Below is a note I took in Evernote on a recent trade I entered. I intentionally excluded the name of the asset traded, because I want to highlight my thought process on how I'm trading, not what I'm trading.

5/22/16: "XXXX 145 SEP PUTS look like a good bet. The risk I'd have to take for one contract is where I want to be relative to assets under management, and the potential reward is high relative to risk. The cost is about $370 per contract. XXXX can realistically touch back down to its 52-week low of $130; this would make my Put contract in-the-money by $15, or $1500 per contract--nearly a 4-1 risk/reward scenario.

I'm using the aggregate of the all-time high price of $213, the 52-week low of $130, the price retracement up to $190, and the continuation of the downtrend as the price headed down to $168, as anchors to determine a high risk/reward opportunity. The opportunity is only viable because the Put contract is aligned with my conservative risk management.

The price of XXXX peaked at $213 on FEB 2015 and hasn't reached those levels since. This trade is a good place to bet on the downside. It will no longer be viable when XXXX goes back to $190 per share."

The Importance of Committing to a Routine

Within the intentional confines of a routine exists boundless opportunities.

The nuances learned each day, compounded over months, years, and decades, creates meaningful progress.

One of the best writers in the world, Seth Godin, writes a blog entry every single day. The action of daily writing for 30 years is what has molded Seth Godin into a world-class writer.    

I go through the same process every day in my trading. I know if I commit to doing the difficult little things every day for the rest of my life, I will carve out a distinct advantage for myself and my investors.     

My daily process allows me to navigate the constantly changing markets. My risk management systems keeps me in the game so I can get a shot at being around for decades.

Quotes from Kovner

In trading highly liquid markets, it couldn’t hurt to learn from someone like Bruce Kovner. He has been trading since the 1970s and has amassed himself a net worth of about $5.3B. The following three quotes are from Bruce Kovner’s interview in Jack Schwager’s Market Wizards.  

“Tight congestions in which a breakout occurs for reasons that nobody understands are usually good risk/reward trades”

“The more a price pattern is observed by speculators, the more prone you are to have false signals. The more a market is the product of non speculative activity, the greater the significance of technical breakouts.”  

“Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep. I know where I’m getting out before I get in. The position size on the trade is determined by the stop, and the stop is determined on a technical basis. For example, if the market is in the midst of a trading range, it makes no sense to put your stop within that range, since you are likely to be taken out. I always place my stops beyond some technical barrier.”

Market Thoughts

You can never succeed in market trading without a belief. A market belief is a strategic frame placed atop the “noise” of a market’s continuous price fluctuation.

I believe that a market’s sole function is price discovery. A market produces a price based on some sort of buying and selling equilibrium.

I believe that in the long term a market will flow toward the path of least resistance.

To think about: betting on a market's upside has infinite return potential. Betting on a downward price move can only reward you until price=0. This doesn't mean that betting on a market drop is a poor strategy; it's a terrific diversifier, but it will not create the same return profile as an upside bet.

Another idea to consider: if you want to see the interconnectivity of markets, follow the price of the US Dollar and notice how other markets move relative to a rise or fall in the $USD. The dollar is trending downward--there’s almost no arguing this. I find it interesting to see what other trends could emerge if the $USD downtrend persists.

$USD chart

A Trading Edge

I believe that trading in markets should be simple in its philosophy, simple in its execution, but extremely difficult for the majority of market participants to stick with in the long term.  

This is a quote from AQR Capital Management’s white paper titled, “A Century of Evidence on Trend-Following Investing”:

“Trends appear to be a pervasive characteristic of speculative financial markets over the long term. Trend-following strategies perform well only if prices trend more often than not. A large body of research has shown that price trends exist in part due to long-standing behavioral biases exhibited by investors, such as anchoring and herding, as well as the trading activity of non-profit seeking participants, such as central banks and corporate hedging programs. For instance, when central banks intervene to reduce currency and interest-rate volatility, they slow down the rate at which information is incorporated into prices, thus creating trends. The fact that trend-following strategies have performed well historically indicates that these behavioral biases and non-profit seeking market participants have likely existed for a long time.”

Price movement is due to human buying and selling decisions by both investors and non-profit seeking actors. Humans are inherently biased, humans make up the markets and humans haven't changed since the inception of markets. History doesn't necessarily repeat itself, but it definitely rhymes.

Gregg Popovic and His Basketball Philosophy

Gregg Popovic began his NBA coaching career in 1996, all 1,574 games with the Spurs. In his first season as the Spurs coach they missed the playoffs. Over the following 19 seasons, they qualified for the playoffs every single year, winning 5 rings along the way.

In the NBA, where head coach turnover is extremely high, Pop has grinded it out for two decades. There is a reason he’s been around so long; he is a flat-out winner. And it never hurts to learn from a winner of this magnitude.

It seems that most of his beliefs about life and basketball are so intertwined, it's hard to separate the two.

If you have any interest in great basketball or success in general, this video is for you.

Hope you enjoy: https://www.youtube.com/watch?v=XBZTPtENQCY

The Essential Tools I Use to Run My System

Finviz.com: Idea generation based on price trends

Barchart.com: Determine and track initial stops/trailing stops.  

Apple’s Stock Application: Stock ticker 

Evernote: Trade planning

GoogleSheets: Spreadsheet 1: Monitor individual trade open risk and aggregate maximum drawdown. Spreadsheet 2: Track system performance on completed trades(individual trade results, aggregate results).

Scottrade: Broker

The tools are useless without a trading philosophy. Ultimately, I buy strength, sell weakness, let my winners run, and cut my losers short.

The tools are a means of staying organized and disciplined.

Broad Framework

“A good traveler has no fixed plans, and is not intent on arriving.”

-Lao Tsu

My belief is that there’s no end-game in trading, or any other area in life. It's all a process of showing up, learning, and calibrating. Ultimately, the bottom line will reflect the quality of the process.

Mania and Depression in Markets

Severe market crashes happen. I believe they are a natural byproduct of markets; absolutely inseparable from the markets themselves.

The human condition of optimistic euphoria fueled by greed has resulted in countless booms and busts.

Throughout history, many economies have experienced tremendous bouts of euphoria which lead to unrealistic asset valuations. The euphoria never lasts and the subsequent crashes prove to be cautionary tales.

From 1985-1990, Japan’s economy went through a memorable boom-bust cycle.

It all started In 1985, when America, on behalf of automobile producers, grain exporters, and engineering companies, convinced the world’s major economic powers to devalue the $USD to reduce their trade deficit. In theory, devaluing the $USD would spur US exports because it would be cheaper for other countries to buy US goods.

Japan gave into America’s proposal and their increasingly stronger Yen caused a massive wave of consumerism in Japan; they had immense buying power.

The Japanese government felt it had to react to the strong Yen. In an effort to compensate for a potential decline in exports, Japan lowered interest rates to spur the country’s growth. Thier intent was to encourage corporations and individuals to speculate with a cheap money supply.    

“The strong yen, low interest rates, zaitech(financial speculation) and the willingness of banks to lend, led to a speculative boom in real estate and the domestic stock market.”  

-The Pit and The Pendulum,  David Harding and James Holmes.  

At the height of the boom, the Japanese Nikkei hit about 40,000, ~+500% on the decade.   

The bubble popped when the Bank of Japan began to raise interest rates in hopes of deflating property prices. As Japanese stocks and real estate were in the midst of a large downturn in 1990, the Japanese government reversed its rising interest rate policy and lowered rates into negative territory to blow air back into the bubble. But the Japanese government was too late; investor sentiment was already dead. The people’s fear of loss outweighed their desire to speculate. Japanese citizens prefered to keep money in a bank account with negative interest rates and lose a bit each year than to risk it in the markets again. Ever since, Japan has been quite risk averse.

Lessons to take away:

1: It's never one single thing that causes a bubble, it's a combination of complex events.

2: Bubbles do not occur in isolation. When economies inflate, many jobs and services are built upon the bubble, so when the impending bubble bursts, the reverberation is widespread.