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Issue No. 16 – March 7, 2005 Prescott, Arizona Systems@WiserTrader.com
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“Buying is taught widely. How one sells can make or break a trade.”
1.0 Trading
Less than 4 weeks left to save 40% on Option Alerts. The free period ends March 31st. Also keep in mind that the newsletter watch lists are more up to date than web site watch lists.
1.1 Southwestern Energy
Southwestern Energy (NYSE: SWN) is an integrated energy company focused on natural gas. It is engaged in natural gas and oil exploration. It produces, markets and distributes natural gas. Exploration and production activities are concentrated in Arkansas, Texas, Louisiana, New Mexico and Oklahoma. The gas distribution segment operates in northern Arkansas and can obtain greater than 50% of its gas supply from one of the Company's exploration and production subsidiaries. Customers consist of residential, commercial and industrial users of natural gas.
The company reported on 2/28/05. For the fiscal year ended 12/31/04, revenues rose 46% to $477.1 million. Net income was up 112% totaling $103.6 million as compared with $48.9 million. Revenues reflect increased volumes of production and higher realized gas and oil prices. Net income reflects lower interest expense and higher margins. A six month chart is in Figure 1.
FIGURE 1
© 2005 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent trades made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser
Southwestern Energy’s stock price has increased 159% over the past 52 weeks. Its price to sales is 4.57, a little on the high side, but its 5 year price to earnings growth, PEG, is 1.25. The trailing PE is 21.7 while its forward PE is 17.5. The stock is a little pricey, except for being an energy stock. SWN is suitable for medium to long term stock investment or as an option trade, as long as, the price of oil stays above $51 a barrel.
1.2 The Discipline
Below are rules that have as much to do with the psychology of trading as the actual mechanics. Some were learned in formal classes while others were learned the hard way. They should be treated merely as guidelines, like the suggestions provided with option alert bulletins. A few have become indispensable reflexes that I follow automatically in areas where I lack sufficient emotional control.
1.2.1 First Hour of Trading
Dr. C. refers to the first hour of trading as amateur hour. During this time of day, the markets have yet to establish a direction. The peaks and valleys that occur in the first hour are fun to watch but can be rather nerve racking when one is about to enter a trade. Professionals do most of their trading toward market close and characteristically trade against novices who trade early in the day. If it has already been decided the previous evening to trade at a specific price, the early hours of trading sometimes offer unusual, but brief, opportunities to sell at a good price. Of course, the opposite can be true as well. One can tell which way the market is likely to break at the initial opening by watching pre-market activity of the S&P and DOW futures relative to their fair values. An up opening does not guarantee an up day. Generally, the morning hours are most erratic and should be avoided.
1.2.2 After Market Close
As a position trader, Dr. C. analyzes the markets after closing using less than half an hour of his time each day. Decisions on buy and sell prices are made every evening. Sometimes there just aren’t any trades to be made. Sometimes there are more than one can shake a stick at, requiring a careful process of elimination and identifying possible contingencies for each potential trade. The next morning, after the first hour, Dr. C makes his trade and walks away from his computer until after the markets close.
I don’t know about anyone else, but I’m a nervous type when it comes to market events. I have a tendency to put my response on the table at once, maybe too early and maybe in the name of some kind of macho decisiveness, to get it over with. When I delay while prices are moving, a very uncomfortable form of oscillatory indecision sets in. Hating that feeling so much makes me want to flip a coin, again to get it over with, and ultimately suffer the consequences. To avoid all that, it is best for me to make as few decisions as possible during trading hours. So I prefer the approach of making decisions after the markets close because it eliminates many mistakes influenced by the excitement of continuously changing prices during the trading day. It reduces stress immensely.
1.2.3 Closing Prices
Implied in the above approach is basing decisions on closing prices. Dr. C says it’s alright to use either intraday or closing prices in decision making. It depends on the temperament of the trader. My reactions to intraday price movement are probably successful up to 50% of the time but with a noticeably higher stress level. Reacting to intraday prices causes me, more often than not, to exit an otherwise profitable trade too early, often at a loss.
Old habits die hard in that I still find myself watching the display during the day like a blinking light junkie. I can’t help it. It’s all I can do to restrain myself from making a knee jerk reaction to erratic price movements. At the end of the day, when able to restrain myself, I give thanks to Dr. C’s approach. That is, I do most of the time.
I had this nagging feeling about a situation that presented itself this past week with the VLO September 70.00 call option that was purchased at $7.00. On 2/28, in early morning trading, the option soared from about $10.50 to around $12.10. The price of oil dipped later that morning sending energy stocks lower. The option bottomed out at around $7.00 and recovered to close at about $10.10. On 3/1 oil dipped again and the option closed at $8.00. Admittedly, I was not monitoring oil prices during the day. The stock closed at an intraday support level of $68. I firmly believe in using trailing stops, in this case a value of -25% was recommended. Those who used the 2/28 intraday high of $12.10 were stopped out on 2/28 at $9.10 for a gain of 30%. Those who used the 2/25 closing high of 10.70 and a closing price of $8.00 on 3/1 had their stop triggered at $8.10. The following morning, the VLO option rose to a high of $8.90 and I was able to exit at $8.70 for a final profit of 24.2%. But it still bothered me that at one point the intraday profit was up by as much as 72.9%.
It was not really a price gap up. A price gap would have called into play the charting principle that, “A price gap in the direction of a trend may signal the end of a trend or the beginning of a new trend”. Looking back, I can find no chart configuration that would have warned me to get out earlier, other than the hunch that a sudden price rise is unlikely to be sustained. “Prices tend to revert to the mean.” This is the basis for using oscillating indicators. Beyond that, there was nothing concrete. Yet I had this nagging feeling that I had stayed in the trade too long by applying the closing price principle, daring not to exit a winning trade too early with the possibility that the stock could turn around and resume its climb. Discipline, in this case did not maximize my gain.
But then that is not its purpose. Discipline is there to protect one from emotional reactions. On further reflection, had I allowed my reactions to take over, I would have sat there like a deer in the headlights until the price stopped falling. Then I would have sold the option when it bottomed at $7.00 for a net gain of zero. Instead, by waiting to make decisions based on closing prices, I ended up with 24.2% profit. So the discipline of basing decisions on closing prices does count for something. “Sometimes you have to consider your potential reaction as an unknown”.
1.2.4 Planning
Position traders, as opposed to day traders, give thoughtful planning to where they want to be when various scenarios take place. When events occur that one has not thought about the previous evening, it gives one something to be more mindful of in future planning sessions. The actual planning session has several components. The first, as you know, is to have a strong watch list of candidate stocks. As a group that uses the wisertrader.com web site, we are well grounded in this area. The lists are reviewed and swept as clean as possible each week.
The second component involves chart analysis, scanning through a 6 month chart of each stock candidate, checking the character of each chart and looking for potential trade entry points based on systematic criteria. This component has been discussed at length and forms a large part of Dr. C’s classes and ongoing help sessions. This task should be performed daily.
The third component also involves using chart analysis, this time to determine when to sell an open position in such a way as to retain current profits, not limit further profits and to minimize losses. This decision is based on support, resistance and other charting configurations. Chart analysis is a critical ingredient of a trading system. It is a subject so vast that it can only be addressed in tiny parts in this newsletter. Chart analysis is based on group behavior. While it is nearly impossible to predict what an individual will do, group behavior is very primitive and highly predictable. The only way to learn chart analysis well is to look at a lot of charts. A point of clarification is in order regarding last week’s comments about support and resistance. Dr C. reminded me in an email on 2/28/05 that:
“Support is defined in my book, "Windows to Wealth" as the point at which price ceases it's decent, repeatedly. Resistance is the point at which price ceases it's accent, repeatedly. These support and resistance lines may be level, up-sloping, or down-sloping. A great current example of support and resistance is seen by drawing a horizontal trend line at 1184 on the S&P. Starting on 11/12/04, the S&P has encountered this line intra-day, either as support or resistance, 16 times.
“Here is one additional point to consider. A support level once broken becomes resistance. A resistance level once broken then becomes support. As you look at the SPX chart you'll see what I mean . . .”
1.2.5 Selling
The fourth component of planning involves money management. This is an ongoing topic that has been discussed at great length, involving both position sizing, profit goal setting and trailing stops. Here is a developing view from the perspective of the profit-loss model of precision money management. The thinking goes like this. It is possible to model and predict profits for any consistent trading system whose performance is defined in terms of statistical averages, such as the one used here. The average fractional gain per winning trade FG, currently at 25%, is treated as an expected profit value. Whenever profits exceed this level, it can only improve progress toward one’s profit goal by increasing the average fractional profit per trade FP and reducing the N, the number of trades needed to earn the average traded amount. This line of thinking concludes that profits should be taken whenever they significantly exceed the expected value of FG. To see what should be considered significant, refer to Figure 2. Just as a reminder:
FP is the average fractional gain taking all wins and losses into account.
FC is the fraction of times the correct direction of trade was chosen
FG is the average fractional gain for winning trades
FL is the average fractional loss for losing trades.
N is the number of trades needed to earn the average traded amount.
FIGURE 2
Effect of consistently increasing FG
Figure 2 shows how FP and N are changed when FG is doubled from its expected value of 25% to a value of 50%. FP increases by a factor of 2.78 and N is reduced by the same factor. Reducing the number of trades needed to meet one’s profit goals by nearly a factor of three appears to be significant. One can use the chart to decide for himself what is significant.
Getting back to the recent VLO option trade, it would have also been wise to take profits on 2/25 when they were a factor of two higher than the expected gain. The objective is profit predictability. If goals can be met sooner than expected by taking higher than expected profits, it is all the better.
Sure, one may leave some potential profits on the table. But there is no reason to risk giving back what is already in hand. When emotions are under control, there is no reason to follow rules blindly. Nor should one be a victim of greed by staying in a trade too long. In summary, a very modest trading system profit expectation of 25% has been established based on historical trading system data. Profits should be taken once the expected trading system profit is exceeded by a significant amount. As a study in contrast, Dr. C states that a profit target of 100% is feasible with his trading system. This target is achievable with a longer holding period allowed by a wider stop loss setting. Additional experience and charting knowledge also help.
1.2.6 Discipline Summary
“Avoid the first hour of trading, as a rule.”
“Perform analysis after the market closes.”
“Basing decisions on closing prices can reduce your stress level.”
“One can not always buy at the market bottom nor sell at the market top.”
“Use strict money management.”
“Take your losses early and let your profits run.”
“Take profits when they rapidly exceed expectations by a sizeable margin.”
“No one ever went broke by taking profits.”
2.0 Market Analysis
Energy and Basic Materials remain the leading sectors. Industry leadership in Table 1 below continues to take a short term view. Leading industries are ranked from highest to lowest.
Table 1
Market Summary
Week ending 03/05/05:
