Category Archives: Trade
In a stock market that seemingly rises everyday it is difficult to be overly confident in any downside trades. That said, history shows us that some of the best bearish opportunities happen when the last of the bears have thrown in the towel and most everyone is bullish. It takes a lot of courage to sell into a rising market. If you are wrong, you will be accused of over thinking the market but if you are right and set up the trade properly, the rewards can be significant. The key to selling into a bullish market is to minimize the risk while maximizing gain potential if you are right and the stock should drop.
One opportunity presenting itself this week is with McDermott International (MDR). MDR is a heavy construction company whose fate is closely tied to the global economy. While the fundamentals can be and are argued in the analysts communities, the setup for technical traders is strong. The setup revolves around 3 primary keys:
1. Earnings reaction. On Aug 6, after the market closed, MDR released a lackluster earnings report. (seen in the chart below) On the 7th, the stock fell over 6% to a closing low of $11.20. Closing lows after earnings typically mark a notable support level. Psychologically, the stock closed at that level because sellers finally exhausted and buyers finally stepped in on a short term basis. The 11.20 mark held until late August. On Aug 29, when the $11.20 level was breached for the 1st time since earnings, buyers reacted by bidding the stock up over $11.50. For technical traders, this action makes the $11.20 level even more important. Trading below $11.20 increases the odd of further selling while giving bearish traders an easy stopping point if the stock moves back over the $11.20.
2. Support and Resistance from the 50 and 200 day moving averages. As seen in the chart above, the stock has been trading around its two major moving averages. The 50 day and 200 day. A moving average is a simple trend line that averages the closing prices over a specified time period. They often help to mark major support and resistance levels. In late June, MDR broke its multi-month downtrend when it pushed above its 50 day moving average. The rally was quickly met with resistance from the 200 day moving average. After failing to break above the 200 day moving average resistance level (even during a rising stock market), the stock has now pushed back below the 50 day moving average. This action lends credence to the bearish argument as the bullish trend that began in June has been broken.
3. Failing Momentum Indicators. Two popular technical indicators, the RSI and MACD help to show stock momentum. While the break below the 50 day moving average shows some downside momentum, the RSI and MACD confirm that downside momentum. In the chart below, note the new low on the RSI after breaking below its multi week support level. The MACD has also pushed below zero showing bearish momentum. These confirming indicators are typical signals seen before a major stock drop.
With MDR, the trade advantage is clearly in the bear’s favor. That said, a good trade has a point at which one says…”My analysis isn’t working. Its time to take my money and look for another opportunity. ” MDR has a very nice stopping point as noted above with the $11.20 price level. Trading MDR lower with a stop above $11.20 gives about $0.20 risk with much higher reward potential should the stock retest the June lows.
Remember, trading stocks lower in a rising market can seem a fool’s errand, but with with proper risk reward setups like MDR, the payoff can be strong. The key to selling into a bullish market is to minimize the risk while maximizing gain potential and MDR gives that opportunity right now for the bears.
The Bearish engulfing is a candlestick pattern that occurs when a bullish candle is immediately followed by a bearish candle that completely “engulfs” it. These candle patterns are very nice for short term traders as they typically signal a 2-3 day pullback in a stock. This pullback can be taken advantage of with an easy stop to control risk.
The image to the right illustrates the look of a bearish engulfing. Note the bullish nature of the stock before the bearish engulfing candle. The bearish candle is then represented by a morning gap higher followed by selling throughout the day. The stock eventually closes below the previous day’s low.
The bearish engulfing price action is typically followed by a pullback in the stock. The severity of the pullback varies from stock to stock but traders normally can capture 2-3 days worth of gains on short or put option position. In some cases driven by fundamental news events like earnings, a bearish engulfing can signal a much more significant top and the beginning of a new longer term downtrend.
Yesterday, the market opened a bit higher in the morning and closed slightly lower. This action helped to create bearish engulfings patterns in many stocks. In fact, 26 stocks in the S&P 500 exhibited these characteristics. While bears can use this action to establish downside positions, bulls can also use the price action to reevaluate their gains and look to take profits.
The trade on a bearish engulfing offers a very easy stopping point that can be used to control risk. If the stock closes above the engulfing day’s high, the trade is compromised and it is time to exit the short or put option position. Typically this type of stop represents relatively small risk compared to the potential gains achieved on a 2-3 day pullback.
There are 3 engulfing plays that I find interesting in the market today. All 3 can be played with stops on the engulfing candle’s day high. The gold miners etf (GDX) may be my favorite as it goes along with my bearish gold thesis. Caterpillar (CAT) and Yum Brands (YUM) represent stocks that have underperformed the market and are more likely to pullback severely if the market falls. Below are the 3 charts. Note that of the 3 stocks, there was only one bearish engulfing that did not work.
CAT had an engulfing on the last day of June that was followed by a rally. One sign that the engulfing was suspect was the gap up 2 days prior. A strong gap especially in a stock on a downtrend can signal that the engulfing may just be a bullish trap. Currently, all three stocks show nice bearish engulfing patterns after a 1 month rally and can be played lower with a stop on the engulfing high.
As China’s economy begins to cool from blistering 10%-12% annual growth rates down to 6%-8% growth rates, commodities have lagged the broader market. Last week, I took a look at the bearish nature of the gold market based on a technical thesis with a rising US dollar. Today, I effort to pose an investment thesis for copper over the coming 3-4 months.
Copper is typically deemed as the only commodity to have a degree in economics because it historically has been the best indicator of future economic growth around the world. For this reason, those who are bearish on the global economy as a whole can use copper as an investment vehicle. Copper has shown little long term effect from quantitative easing from central banks around the world. Where stocks can rise in the face of economic turmoil due to outside stimulus, copper is more likely to accurately reflect the state of the global economy. Below are my top 3 reasons why copper is set to go lower over the coming month.
Reason #1: One of the most solid bearish arguments for copper can be made on the thesis that China’s economy is cooling as is not likely to see the 10%-12% annual growth numbers again. Donald Straszheim, Senior Managing Director of China Research with ISI Group, said, “The boom days (in China) are almost certainly over. I think China’s growth rate is slowing and slowing a lot. And the old era of 10 percent growth is going to become the new era of 6 percent growth. So the world is going to begin to absorb the idea that there’s going to be weaker demand for a lot of these commodities for a long time to come.”
Mr Straszheim’s argument is very fundamental in nature but is echoed from many around the world. Below are some of comments being made collected by Andrew Gordon in his article, ‘Can you handle the truth about China’.
- Average Chinese GDP growth this decade will not exceed 3% (Peking University Economics professor Michael Pettis)
- “A one-in-three probability” that China will experience a hard economic landing before the end of 2014. (Nomura, the Japanese financial services firm)
- “Some argue that China might already be in recession…” (Foreign Policy magazine article called “Five Signs of the Chinese Economic Apocalypse”)
- A “ghost fleet” of Chinese shippers plying the open waters in search of freight to transport, as if “out of the shadows.” (Evan Osnos, The New Yorker)
- China headed for a “hard landing of epic proportions.” (Jim Chanos, hedge fund manager)
- “China has all the earmarks of a classic mania that will end badly…” (Edward Chancellor from GMO)
- “Huge downward pressure” from slowing consumer demand in Europe and real estate speculation at home. (Prime Minister Wen Jiabao)
While China’s economy may or may not be headed for an epic crash, the days of supersonic growth are behind it. A major growth engine for the price of copper is drying up.
Reason #2: Long-term charts for copper are looking very suspect to further decline. The 1st chart below is a chart of JJC, the copper etn. Since the reflation of the markets in 2009, copper has failed to achieve gains. While bobbing up and down, the pattern is very clear. Most market technicians refer to it as a head a shoulders reversal pattern. A head and shoulders pattern is an rather accurate pattern seen ahead of a major reversal. The present head and shoulders pattern has not yet confirmed a breakdown, but another 1%-2% decline would break major support levels and signal a 12%-15% further decline in the coming months. The longer term implications of the pattern put the JJC below 30.
While the head and shoulders pattern is considered by many to be a voodoo like interpretation of a chart, an ABC correction pattern is more accepted in technical circles. An ABC corrective pattern typically happens after a long term rally. The ‘A’ part of the move is the initial selling or profit taking seen in the 1st half of 2011. The ‘B’ move is where buyers step back in as they feel the stock or commodity is oversold as seen in the latter half of 2011. At present, copper is in the midst of a ‘C’ move. The ‘C’ move can be the longest, most drawn out move that typically retraces the long term rally by 62%. If copper keeps with its present ABC corrective pattern, the price target is around $35, similar to the head and shoulders target seen above.
Reason #3: The US dollar and Copper are negatively correlated. A negative correlation suggests that when one thing rises, another falls. This is the case with the US dollar and copper. Historically, when the dollar rises copper falls and vice verse. There are many technical signs suggesting a rising dollar which naturally suggests falling copper. In the chart below, the negative correlation is evident but with 3 key exceptions. All 3 exceptions revolve around quantitative easing programs by the US Fed. When the easing programs were put into play, the correlation between copper and the dollar became very little but when the programs effects wore off the negative correlation returned. Given the presidential election in the US is only a few months away, I doubt the US fed is going to enact anymore QE programs for fear of being deemed as influencing the elections. (more to come on this topic)
The Trade: Given the bearish arguments for copper, what is the trade? There are several options.
- Buy the 2x inverse etf for copper, SCPR. It will rise as copper falls at approximately twice the rate.
- Buy put options on JJC. The spreads on these puts are large so I would suggest deep in the money puts at limit prices where the spread is reduced. For example, the DEC 12 60 puts for $17-$17.50.
- Put options on copper miners. These can be a bit more tricky in a rising stock market but pay off big if stocks and copper fall together. FCX and SCCO are solid candidates.
Technical confirmation of a downside trade is had with a move below $41.50 on the JJC. The bearish technical thesis on copper is severely compromised if copper moves above $3.55 or $45.5 on the JJC. These levels can be used as stopping points to minimize risk. With 12-15% reward potential on the downside and 4-5% risk, the 3:1 reward to risk ratio makes for a solid trade.
After months of consolidation in the gold market, a very nice trade setup is happening. Short gold and long the US dollar. Historically these two asset classes are negatively correlated meaning that when gold rises, the dollar falls and vice-verse. While there are many fundamental arguments to a rising dollar and falling gold, the arguments are subjective and irrelevant when it comes to managing trade risk. Because of the subjectivity, my trade setup is simply a technical one in order to quantify my risk and set realistic price targets.
Below is a chart of the UUP which is an etf for the US dollar. The dollar hit a high in May/Jun of 2010 . Understanding that a rising dollar contributed very little to the US economy, the Fed set out to devalue the dollar through is quantitative easing polices. Currency markets responded by selling the dollar while gold markets watched the price of gold shoot up 40%. The quantitative easing policies have continued from the fed but the effects on the US dollar and gold are wearing off. This can easily be seen by the recent rally in the US dollar.
The chart pattern on the UUP is a rather unique but accurate rounding bottom reversal pattern. Rounding bottom reversals typically reverse slowly and gain momentum before shooting higher. Currently the dollar is building upside momentum and the tendency would be for a major rally to come.
I continue to be a dollar bull…at least for the coming 6-9 months barring any major technical changes. $22.25 becomes a nice stopping point for the bulls to manage risk while a price target of $24.00 would be rather conservative. Due to their negative correlation over time, a bullish view on the US dollar would naturally lead to a bearish view on gold.
The simplest bearish argument on gold is the fact that a multiple year downtrend was broken earlier this year as seen in the chart above. In the chart below, the retracement of the strong rally is noted. A 32% retracement occurred at the beginning of 2012 and gold shot higher as many who missed the 2011 rally used the retracement level to pile in. When that buying pressure ran out, gold ultimately failed to set a new high and broke its major up trend.
At present, gold sits back at its 38% retracement level with many signs pointing lower.
- major uptrend broken – already discussed
- typically when a 38% retracement acts as support once, it fails to act as support again.
- when the 38% retracement fails, a move to a 62% retracement is common.
- after an explosive rally as seen in 2011, a move back to a normalized trend is typical. (as seen in the blue dotted trendline)
While gold sits at its 38% retracement, it is consolidating. This consolidation began in May and is still taking place. This consolidation is part of the natural movements in stocks where they consolidate then trend. One way to spot a coming trend or consolidation period is by using the ADX. After a stock has consolidated, the ADX is typically low. When the trend phase begins, an upturn will be seen in the ADX. When a stock has been trending and is ready to consolidate we typically see a downturn in the ADX. Its important to note that the ADX says nothing about directional movement. It just assists in recognizing when a stock is ready to move.
At present, the ADX on gold is extremely low. It has yet to turn higher so the consolidation phase of gold is still in effect. When the ADX begins to turn higher, a breakout in gold will follow. With the bullish nature of the dollar and the bearish technical aspects of gold discussed above, I expect to see a breakout to the downside. Confirmation of that downturn would be a move below 153 on the GLD. A move above 159 would negate some of the bearish technicals and can therefore be used as a stopping point.
With GLD sitting at $157.60, setting up a short position ahead of a potential breakdown may be premature but offers very little risk if the trade does not work. With a stopping point of $159, the risk is $1.40 with a reward potential on a breakdown in excess of $10.00.
On July 26, the shares of social online game maker ZYNGA (ZNGA) fell almost 40% as their earnings report disappointed investors. To add to the disappointing earnings, a more traditional gaming company, Electronic Artists (EA) issued a lawsuit against Zynga. EA accused Zynga of copying key elements of “The Sims Social” title, alleging that Zynga obtained confidential development information by hiring three of EA’s top employees.
So what does this have to do with Glu Mobile (GLUU), our trade of the day? The weak earnings from Zynga caused investors to hit the panic button Glu mobile sparking a response from Glu management. During the midday trade, Glu management pre-announced their earnings which calmed investors by highlighting some of the differences between GLUU and ZNGA. “Glu’s strong year-over-year growth was powered by our mobile-focus, lack of dependence on Facebook web users, and strength in male-oriented games.” noted, CEO Niccolo de Masi. In an interview, de Masi noted the growth focus as gamers move from traditional gaming into tablets and phones. They are uniquely poised to take advantage of the continued mobile battle between Google, Amazon, and Apple.
From a long term investment standpoint, GLUU is well positioned to deliver great value to their shareholders. So what entry price is ideal? The $4 level is very interesting. In the chart below we can see the strong technical breakout in late March. This strong volume move above $4 has been challenged several times with strong volume buying entering the stock each time. Given the overbought nature of the stock market, lingering effects from ZNGA, and technical base of $4 on the chart, I suspect GLUU gets a bit cheaper in the short term. Looking to buy in the $4.00-4.10 level offers strong value for both long and short term investors in a company uniquely poised to take advantage of the mobile and tablet craze.