Felix Chapovsky

I have read a number of blog posts mentioning the “sell in May” tune and for the last two years they have been right. Other posts bring up the fact that the economy is much healthier now than it was in 2010 and say this “dip” is a buying opportunity. Of course nobody knows when the market will turn around, all you can do is make decisions in real-time on whatever information is currently available but right now I would say it is not like 2010 or 2011, it is in fact much worse.

Below are the weekly charts of both the USD and the GLD. We can see that back in the summer of 2010 and 2011 in the heat of the first European debt crisis and prior to QE2 there was a “flight to quality” where both the USD and GLD were making new highs. What about now? We have the USD looking like it wants to make a new highs but GLD is breaking down and looks to have a lot of room to head lower.

To me the current environment is not like the summers of 2010 or 2011 at all. The dollar is going up but with GLD going down  investors aren’t even focused on “flight to quality”, just an extreme “risk off” mentality. I am not saying  this is 2008, but the European situation may get much worse and I think the sell off in GLD is a harbinger of even more selling of other asset classes. Caution is warranted.

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The market has significantly changed character over the last month or so and this can be seen by comparing the relative performance of the S&P SPDRs. Over the last 29 trading days the top performing sectors have been consumer staples, healthcare, and utilities. Consumer discretionary has been hanging in there but has certainly been taking some heat lately.

The XLB (Materials) looked like it was poised for a breakout a few weeks ago and would have been a good overall sign for the market but the price action over the last few weeks has shown some deterioration which makes this less likely. Currently the XLB is sitting around 35 and a breach of this support level would argue for further downside in the general market.

The XLF (Financials) is at a critical level and a break below support here would be a significant negative and even further evidence of a likely worsening trading environment over the summer months.

The XLI (Industrials) has a similar look to it.

Overall we are clearly in a defensive posture and a break of the above levels would be a sign of worsening market conditions and something to be on the look out for.

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With big selling in a number of former leading stocks starting to show up and deteriorating market conditions a number of stocks are beginning to set up as potential shorts. Here are some ideas I am monitoring currently.

CF was looking good as it broke out of this base last week but with the deleterious action in the general market this one reversed below its pivot on big volume and is slowly turning into a failed breakout type of situation. Also, other names in the fertilizer space such as MOS, MON, IPI and POT look horrible so maybe this one will get in line with the others. I wouldn’t short here as it is very close to support around the  178-180 price level but a weak bounce could be shortable.

GOOG has been showing a number of warning signs on its weekly chart that at the very least are telling you not to be long this stock. Look the weekly reversals each time an attempt at new highs were made in 2012. Also, notice the big volume selling over this same time period relative to the buying volume. Currently price is stuck between the 10 week and 40 week moving averages. A resolution of some kind will be coming shortly and this appears more than likely to be resolved on the downside.

SCSS looks to be setting up in a potential H&S topping pattern going back to last October when this most recent rally began. Look at that weekly volume which is the largest since the market bottom and is a sign that big holders are selling. The stock is bouncing off the 40 week moving average right here so I am looking for it to form some sort of right shoulder on any general market bounce to short into.

I would not be shorting here given that the Nasdaq is sitting right at the 2900 level which is clearly defined support and so a short term bounce is likely here. This bounce, especially if it occurs on low volume, would likely be associated with a low volume rise in the stocks mentioned above and could present us with some low risk-high reward short sale situations.

For now I see absolutely no reason to be long at all. The market action today has the smell of forced liquidation and nothing is being spared. It seems that everything is being hit including precious metals so this is not even a “flight to quality” environment but rather a “risk off environment.” Best to keep cash levels high and wait for more opportune times.

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Trading is a very tough endeavor and not an easy way to make money. In fact, there are far easier ways to make money. Trading requires patience, persistence, and an almost obsessive attention to detail. You spend a lot of hours in front of the computer reading articles and looking at charts so you can be well prepared when the opportunity presents itself.

What is the allure of trading that captivates so many people willing to invest much of their time and money into this pursuit? Of course, it is the dream of easy riches isn’t it. These people eventually realize that there is no easy road to riches and leave or eventually just blow up their account and move on.

But for the rest of us that understand what a challenging road this is, we eagerly await the next trading day with fresh eyes and enthusiasm because every new dawn brings another potential opportunity to put our skills to the test to try and make money at this fascinating enterprise.

While trading is intellectually stimulating and certainly a lot of fun, it does come at a cost.

Yesterday as I came upstairs my son was sleeping in my bed alongside my wife. As I picked him up to carry him to his room, a feeling came over me as I made the quiet walk down the hallway to put him in his bed. It took me no more than 15 seconds to get down the hallway but for some reason this time it felt different, like a whole week had passed.

I was so intently focused on everything going on around me it was strange. I could feel his warm tired arms bouncing off of me. His little feet were dangling in the air and I could feel them as they banged against my knees as I walked. First the right one, then the left one. Repeat. I kissed the top of his head and let my lips just rest there as we made our way. As I put him in his bed, I thought why is it today that I have this unique feeling of heightened awareness. I do this all the time but what is different now.

And then I thought maybe it is because I have been distracted for the last few months by the market. During an uptrending market when there is an opportunity to make money, I focus so much of my attention on trading that I leave little time for much else. But now with the market in a correction I have more time for other ideas to flow into my head and I am free to think about other things.

I thought to myself how I am not capitalizing on the greatest opportunity of all. Here I have this little man in front of me who idolizes me. He doesn’t care about earnings season. He doesn’t know about the French elections or that Greece is done for. All he wants from me is to spend time with him. Am I too distracted by the markets? Am I failing him as a father?

Don’t get me wrong, when he comes home from school I stop working. We have dinner, we play, maybe watch a cartoon before bath time. But does he really have my full attention, that is the more relevant question.

Methods of a Wall Street Master by Trader Vic is one of the top 5 trading books ever written, in my opinion. Not just for detailing his trading methodology, but a large portion of the book is devoted to self-awareness and the pursuit of happiness as it pertains to trading and life in general. A quote from the book :

“A compulsive desire to be rich may indeed drive you to learn about the markets and make money, but only at tremendous personal cost. A driving desire for fame usually has at its root a fundamental lack of self-confidence and self respect, and any fame achieved on that basis will be empty and meaningless. The extent to which you are motivated solely by the desire for money and fame is the extent that you will fail as a person, and usually as a businesspersons as well.”

He also says:

“To be rich and famous is not synonymous with success…success isn’t achieved through the attainment of any particular goal – it is a state of living.”

While many of us are focused on our trading, are we neglecting other things in our lives that could bring us even more joy than making money? Life is a balance I guess and to be successful at trading takes time and there is never enough of it. There is a constant battle for our attention and the duel between our professional and personal lives is ever constant. We must make choices as to what we will spend our precious time doing but we often need to evaluate if we are making the right choices.

After I put him in his bed, I lied down next to him and hugged him close. No winning trade in the world feels this good I thought to myself, and I don’t even need to work for this.

Wall St. analysts get very little respect by real financial professionals, and by real I mean those people that are accountable for their recommendations and actions. Josh Brown wrote an interesting post a while back about GMCR showing all the buy ratings on the stock despite its problems and how analysts are wrong and continue to be wrong. You can read it here. 

This got me thinking a little bit about the actions this past week in HLF, a stock that also became a victim of David Einhorn following the company’s earnings conference call. I read a really good post on seekingalpha that discusses Einhorn’s questions and HLF’s response to them and provides a nice summary of the transcript. You can read the article here. 

Despite the decimation of HLF, there is a statement in the article that I found amusing:

“Analysts, however, rushed to Herbalife’s defense, claiming … that the stock now presents a great buying opportunity.”

It also goes on to say

“If anyone else had asked the question we would have wondered why time was being devoted to such basic inquiries… This was an excellent quarter from an excellent company with high ethics and strong accounting. We have no problem remaining bullish no matter who is asking the questions.”

I like that, “no matter who asking the questions.” While many are saying the response to the questioning was overblown and that it did not justify a 20% drop in the stock price, these are the questions from a man that has earned a certain amount of respect in the past for being right. When he presented over 100 slides last year detailing the issues with GMCR was there any doubt that he did not do his homework? Were the issues he raised not justified? Was he wrong about Lehman?

As traders we have to make our own decisions but we do care what other “real” investment professionals think. Before you buy a stock, you would like to see increasing institutional sponsorship as a sign that others with a good track record are also buying this stock. If Fidelity just increased their position size in a certain stock this provides another piece of evidence that there is a higher likelihood of a price advance.

Well the same can be said in reverse. I think Einhorn is smarter then all of these analysts put together and if he has concerns about HLF business practices then he is probably right.  The “real” professionals know it and that is why the stock tanked, because unlike analysts it really does “matter” who is asking the questions. 

First let me say that I never even heard of Peter Brandt before stocktwits but without a doubt his posts are no joke and contain some of the best material on the stream. Hats off to stocktwits for bringing someone like this into our world. I guess this is what social media is all about.

I have been seriously trading for about 5 years now and have read about 50 books. Of course I have read all the greats such as Reminiscences, Battle for Investment Survival, Methods of a Wall Street Master (all more than once) and the rest and I love these books. I would listen to Reminiscences on my ipod over and over and it never gets old. If you have not heard the audio version I highly recommend it.

The one thing that interested me in Diary of a Professional Commodity Trader is that it is less about the actual trading methodology (although there is plenty of that if you want to learn exactly how “he” does it) but more importantly at least for me is how does someone go from trading as a hobby to becoming a professional and doing this as a living. Not in terms of being mentally prepared but how do you actually do it, literally? How many trades do you make a day, week, or month? Your position sizing? How do you pyramid? How do you scale back when the trade is going against you? Your average win:loss rate? All important things to consider if you want to trade for a living.

There are many books discussing methods for each of these topics but reading something in a book and actually putting it into practice is a different story. There are tons of books out there that show great setups and proper buy points that any half decent trader would be able to identify but realistically this will not help you make money. It is very easy to spot a buy point on a long-term daily chart of AAPL and say “Just buy here and you would be up 300%” but it is an entirely different thing to make the decision in real time and hold it.

The reason I bought this book is because it claimed to do exactly this, walk you through the thought process of every trade by someone who earns a living trading for 21 weeks. See all his wins and all his losses, all his successes and all his mistakes.

There are too many good one-liners throughout the book to mention but I will offer just one here.

“You have spent 90% of your effort on the least important of trading components: trade identification…trade identification is the least important of all. In my opinion, learning the importance of managing losing trades is the single most important trading component.”

There is so much wisdom in this one line I can’t do it justice. The reason I pick this quote from the book is because at least from my own experience when I started this is where I spent most of my time, trying to find that one big stock that would make me a killing. Guess what, it didn’t work. I spent very little time concerned with risk management and what to actually do once I was in the trade.

To reiterate what Mr. Brandt is saying, finding the right stock to buy really is not that hard. A few good screens or even just the IBD50 list will give you enough names to make you money if you know how to handle them right (if you are a momentum investor like myself). What is far more important (and I have learned this the hard way as most traders eventually do) is that risk management is priority #1. That is why this book is so good because he doesn’t just say “cut your losses” but rather shows you “when I make a trade and it goes against me, this is how I exit.” The whole book is about how he puts “theory into practice.”

One more thing, just because this is how he does it, he does not mean to suggest that you should do it that way. That is not the point of the book. You need to learn from others who have succeeded but develop your own system that you are comfortable with otherwise you won’t believe in it.

I know value guys that make money but that is something I could never do. I can’t imagine buying a stock as it is making new 52 week lows and then adding more shares as it heads even lower. That is not me but that doesn’t mean it is wrong, just wrong for me.

I will not give away any more of the book but let me say that it did just what it claimed to do. This is as close as you can get to sitting side by side to a real professional and someone that puts food on the table by trading. If you are seriously interested in trading this book is definitely a good read. If your aspirations are to one day do this for a living then I would say it is a must read.

I read a post this morning from @chessNwine which you can read here. He highlights the current potential H&S top like formation in BRCM that may be forming. Go read his post as he goes into this in some more detail but one sentence in particular stood out to me.

“From failed head and shoulders tops (of which there are plenty in the history of the markets), usually come aggressive moves higher.”

This is a very insightful statement and something that I myself have noticed numerous times and more importantly, failed to act when this occurred. As an example look at PCLN from 2010. These are the actual notes I made on the chart in real time as they occurred.

I was planning to short this stock for the following reasons.

1. The stock had a big move from from when it bottomed in October ’08 at $45.15 to a high of $273.93 in April 2010, a gain of over 500%. I am not into shorting stocks making new highs but the weekly chart showed a developing H&S topping pattern. Notice the large selling volume that created the right side of the head that took the stock lower than the left shoulder. Also, the best short sale candidates are the biggest winners of the previous bull run. Institutions own a lot of shares of these stocks and therefore there is a lot of supply when these start breaking down.

2. When shorting stocks you need to also look at what the general market is doing and if you recall this is the time that the “flash crash” occurred and it looked like all hell was going to break loose. At the very least it looked like we were moving into some sort of correction and so I felt I had the market on my side.

3. Let’s take a look at the daily chart now. You can see the developing H&S pattern and my thought process that occurred during this time. Notice the big volume decline that formed the right side of the head. Also notice that as the right shoulder was forming volume was declining which was another good sign when looking to short a stock.

There you have it. This was a well thought out and planned short sale attack. I am telling you I was almost counting the money, that is how certain I was this was going to work. I had been following the stock for months planning this campaign and it was finally going to pay off. I had planned on everything except one thing, look below.

The stock gapped up big time as it was in the process of filling out the right shoulder on some serious volume. From this failed H&S topping pattern PCLN continued to rally to new highs and of course now PCLN is sitting at $761.00, an almost 300% move from where it gapped up that day.

My mistake when this occurred was not to start looking to get long this stock. The lesson here, when a stock does not act the way you think it should and acts convincingly to the contrary, it is often a very powerful sign that a move may occur in the opposite direction.

There were some warning signs over the last few weeks both in the market indexes and among leading stocks that should have made you at least a little cautious and caused you to decrease your exposure so today’s sell off should not be hurting that bad.

1. Market indexes showed distribution – This is the daily chart of the Nasdaq and is the index you want to pay attention to if you are a growth investor because most of your big leading stocks will be coming from here. There have been a significant number of distribution days over the last few weeks which is an indication of institutional selling. The most important thing to keep in mind here is that SELLING HAPPENS ON THE WAY UP AS THE MARKET IS STILL GOING HIGHER.

Market breadth also decreased during this same time period so while the market was moving higher, leadership itself was decreasing. The market was moving higher albeit with fewer and fewer stocks.

The weekly chart of the Nasdaq also shows that there was some inherent weakness last week as the index closed near the lows of its weekly range as volume increased. In and of itself not an ominous sign but taken in combination with a number of other factors indicating weakness it was a telling sign.

2. Leading stocks showing some weakness – If the market is moving higher but breadth is decreasing then this should be evident in the number of stocks that are unable to continue making new highs. It is the leading stocks of the current uptrend that deserve special attention because when these leaders begin to show weakness it is usually a sign that a change in market conditions is right around the corner.

A number of leading stocks started to show some weakness over the last few weeks and this was the canary in the coal mine. There were still plenty of stocks that continued to look very strong and make new highs but when taken into context with the weakness in the indexes it was something to take note of.

3. A number of leading stocks began forming bases – This is actually a very good thing because these new bases will set the stage for higher prices later on but certainly is in line with the decreasing breadth seen over the last number of weeks.

The recent market distribution, failure of some leading stocks to hold their breakouts (I was stopped out of a few of these), and base forming seen in other leading stocks caused me to decrease my exposure from 85% over the last few weeks to only 20% going into today.

There is absolutely nothing wrong with a market correction and I actually like the action of a number of stocks some of which are shown above. Pay attention to the stocks that are forming bases right now and those that go down the least if in fact we do get a a significant market pullback, these will be some of the best winners when the uptrend eventually resumes itself.

Many traders spend most of their time on trade identification. While this is a very important aspect of trading the appropriate use of risk management often gets far less attention and this is usually the downfall of most traders. There are many questions you need to ask yourself before you place any trade but the two most important are

How many shares should I buy?
If the trade goes against me at what price do I know I am wrong and need to get out?

This is where the art of trading comes in. You could have two traders with the same account size look at the same chart and you will get two different answers depending on their risk tolerance.

Let’s take a look at the following charts and see how risk can help you choose which one of these potential trades to take.

Below are weekly charts of FIRE and HSTM.

Both charts are in uptrends and they are both leading stocks that had big moves last week. Let’s look at the daily charts of each and see how we can use risk to see which one is better from a risk reward perspective.

First, let’s look at FIRE. You can see the big volume gap up with volume pulling back the past two days. If you use the low of the gap up day as your stop you are looking at a 7.8% maximum stop, more or less.

Now, let’s look at HSTM. Here we also see the big volume gap up move with volume pulling back the last two days also. In this case the low of the gap up day is 16.2% away from the current price.

So the question now is which stock would you rather buy? The answer is it depends. Both charts look hot and you could take a position in either one but knowing where you will get out will determine your position size and how much risk you are willing to take.  If you decide to buy HSTM you would just buy fewer shares to give yourself a wider stop depending on how much capital you are willing to risk on any trade.

I am not saying you should buy these stocks using stops at these levels and I don’t own either of these stocks right now. This is just an example of how you should go about looking at risk reward to help decide which stock and how many shares you want to buy.

Trading is all about risk management. The most important thing is to stay in the game so you can find the big stocks but unless you know how to manage your risk a few bad trades will clean you out. There is no easy road to success in trading and this is a very long and slow process, but in the end the result in worth it.

Felix

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In order to improve your trading it is critical to evaluate your performance. This means reviewing your trades so you can identify mistakes you may have made (there always are) because even if you have a great trading strategy your implementation of that strategy may be flawed.

The Nasdaq has rallied almost 20% from the December trough to the February high of two days ago and is up 11.5% year to date.

It has not been that hard to make money so far this year but it is not like it is falling off of trees or anything. There is no question that breadth has been improving (although it has declined recently) and there is some leadership. However, with a double digit rally in the Nasdaq although I am making money, I am still underperforming the market.

The biggest reason for this is that for the most part this rally has been led by the laggard stocks. Bespoke wrote a great post titled “Losers Become Winners” a few weeks ago where they highlight this so unless you caught the exact bottom and bought the worst performing stocks of 2011 it would be tough to be outperforming the major indexes at this point in time.

More and more stocks are setting up which is very constructive. The first pullback (which we may be in process of) will be very important because this is when the true leaders will differentiate themselves from the crowd. Remember 2009, you did not need to catch the bottom because the real money was made after July when the head and shoulders pattern that everyone was writing about failed.

This means that the big opportunity in 2012 may present itself in April or maybe even later so if you are not doing as well as the major indexes this is nothing to be concerned about. If this rally continues there will be plenty of names that will allow you to catch up very quickly. Just stick to you strategy and manage your risk.