Dear Daily Crux reader, –––––––––––––––––––––––––––––––––––––––––– The Daily Crux Sunday Interview The Daily Crux: Let's move onto another concept: breakouts. As you can see, the concept of an "upside breakout" is simple. It's when the price of an asset moves into a new area of higher prices. In oil's case, that move in early March took crude to its highest closing price of the past 60 days. Traders call that a "60-day upside breakout." After peaking at $240 in mid-June (A), Potash drifted lower into the $200 per share range. It then staged a downside breakout in August (B)... taking shares all the way down to $180. The chart above displays the share price action of oil company Suncor from mid-2008 to mid-2009. To sum things up, waiting on price breakouts – either short-term or long-term – before trading increases your odds of success because you are getting in line with the market. You're going with the tape, rather than against the tape. That's all you really need to know about this simple but critical technical concept. Note that in June and July, the red bars (days Potash declined) started to get just a bit bigger than the black bars (days Potash advanced). This is an early sign that sellers have more power and more conviction than buyers. Entire books have been written about volume analysis, and many traders use sophisticated formulas to track volume trends. But for the great majority of traders, these two guidelines are all you need to know about trading volume. You need to know that it often signals the end of big trends... it signals market extremes. Most of the time, this volume analysis isn't going to tell you much. Here are the guidelines one more time: One... when an uptrend enters a period of huge selling volume, it's a sign the trend is near an end... a sign the big money is cashing in and bailing out. And two... when a downtrend enters a period of huge buying volume, it's a sign the trend is near an end... a sign the big money is seeing value and buying up shares. Crux: That's a great set of common sense tools. Anything you'd like to leave the reader with?
Last week, we continued our series of "The World's Greatest Investment Ideas" with part I of an interview on "Common Sense Technical Analysis," with Stansberry & Associates Editor in Chief Brian Hunt.
Below, we present Part II.
This week, Brian covers the secrets to profiting from "breakouts," how you can develop a "sense" of the market, and how the world's best traders use trading volume to greatly increase their profit potential.
Read on to learn more. If you missed part I last week, you can find it here.
Regards,
Justin Brill
Managing Editor, The Daily Crux
www.thedailycrux.com
The World's Greatest Investment Ideas:
Common Sense Technical Analysis, Part II
Hunt: In addition to knowing how to identify a trend, it's crucial the trader learns how to identify a breakout.
A breakout occurs when the price of an asset reaches either a new high point or a new low point for a given time period. An "upside breakout" is when the asset hits a new high. A "downside breakout" is when an asset hits a new low.
Breakouts can be either short-term (about five or 10 days) intermediate-term (like more than 30 days) or long-term (more than 200 days).
Breakouts serve as a starter's pistol to signal the beginning of a trend. No uptrend can start without an upside breakout.... And no downtrend can start without a downside breakout. Let's look at a few examples...
After suffering the big decline of the late 2008 credit crisis, crude oil traded sideways for months before staging an upside breakout around $48 per barrel in mid-March (A). It then proceeded to drift sideways in the high $40s before staging another upside breakout around $55 per barrel in early May (B).
Now let's look at a downside breakout.
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The chart below displays the downside breakout in shares of Potash during the summer of 2008...
This was the lowest closing price in 90 days for Potash... So you can understand why we call this a "90-day breakout." Keep in mind... it's also a 60-day breakout, because if shares are hitting their lowest level in 90 days, they are also at a 60-day low... as well as a 30-day low and a three-day low.
Breakouts are important because they signal possible trend changes. If you are looking to trade an asset in one direction, it helps to wait on a breakout before making your move... It helps to wait for the market to "confirm" your belief.
Waiting for a bit of price confirmation ensures you aren't fighting the tape... or placing your money into assets that are drifting sideways for long periods of time.
For instance, let's say you turned bullish on crude oil in February 2009.
Waiting on that upside breakout in March ensures the market is moving in your direction. It ensures you are trading with the trend... no matter how short- or long-term your horizon. The same goes for a trader looking to bet against Potash...
Let's say you wanted to short Potash in June. You'd want to wait for a breakdown to signal a trend change before making your trade. You'd want to see some share price weakness to confirm your thesis. Even if it's just a bit of share price weakness – say in the form of a short-term five-day downside breakout – that's considered waiting for market confirmation.
Following breakouts is no Holy Grail of trading. Breakouts can reverse in a hurry. When an asset stages a break out in one direction, then turns right around and heads in the opposite direction soon after, it's called a whipsaw. Whipsaws are just a fact of trading life. Below is an example of a whipsaw...
A trader bullish on Suncor might have bought shares when the stock staged a 60-day upside breakout near $22 in late December (A). That trader would have had to endure a sharp whipsaw down to $17.50 per share in the following weeks (B). Depending on where a trader has his stop loss, this whipsaw could kick him out of the trade.
Below is the same chart of Suncor, with a few more months' shown. You'll note that Suncor eventually broke out of that $22 area and ran into the high $30s (C)... but there were a few months of sideways "whipsaw action" that a trader had to deal with.
This is simply how the market works... one must deal with these situations by sticking to your protective stop loss orders... and knowing from time to time you'll have to deal with whipsaws that nearly trigger your stop losses, kick you out of trades, or produce a few months of frustration.
Crux: What are some other common sense tools one can use to spot market tops and bottoms?
Hunt: We'd better cover "acting well" and "acting poorly." These are two more things that aren't trying to predict anything... they aren't "reading tea leaves"... they're just common sense tools that help us time trend changes. Let's go back to our Potash example from mid-2008.
Remember... back then, Potash was in the middle of a huge bull market. Shares were up 700% in two years. Tons of CNBC guests talked about how bullish they were on fertilizer stocks. You'd hear stuff like, "Things couldn't be better for the industry."
Retail investors across the country started hearing about high crop prices and rising fertilizer shares on the nightly news... And they started reading about them in the local paper. Food riots broke out in Mexico and Indonesia. Fertilizer companies were reporting incredible increases in revenue and profits. The Market Vectors fund family even launched a new agribusiness ETF to capitalize on investor interest toward the sector.
Then... on July 24, 2008... Potash came out with a stunning earnings report.
Earnings came in at $905.1 million... a 220% increase from the year before, and the highest total in company history. "This quarter established a new standard of performance for our company," CEO Bill Doyle said. Shares fell 3.3% on massive trading volume as a result.
Yes... I said "fell," not climbed. Potash reported the greatest quarter in company history... a "new standard" in profitability... and was clobbered for it.
This horrible performance in the face of great news is what happens when a trend is changing. It's called "acting poorly"... and it's another vital technical concept to know.
As you can imagine, when an asset cannot rally in the face of wonderful news, it's a huge bearish sign for that market. It's a sign that all the great news and all the great fundamentals going for the market have been "priced in" to that market. It's a sign there aren't enough buyers in the market to help drive prices higher. They've been exhausted.
Just as it's bearish for a bull market to fall on great news, it's bullish for a bear market to rally on horrible news. Consider the case of Intel...
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In April 2009, things were horrible for Intel. This was around the time of the 2008-2009 credit crisis. Many folks were worried the "The Great Depression Part II" was around the corner. Intel shares fell more than 50% in four months.
Intel is the world's largest maker of semiconductors... the tiny "engines" that power the world's computers. If another Great Depression was in the cards, people wouldn't be buying computers... and Intel's business would suffer.
In mid-April, Intel reported a huge quarterly sales decline of 26% from the previous year's quarter. Profits fell 55%. Intel also offered a "blurry" outlook for the rest of the year. Wall Street hates "blurry." So what happened to Intel shares after this news? They held like a rock!
When a bear market has a bullish reaction to horrible news, that market (or stock) is said to be "acting well." It's a sign the sellers of that asset are exhausted and out of ammo. It's a sign the downtrend is likely finished.
In Intel's case, the downtrend was finished. The stock rallied 50% over the next 12 months and was one of the top-performing stocks of the year. This rally kicked off when Intel started "acting well."
To summarize, when a bull market sells off in the face of great news, it's a bearish sign. When a bear market rallies in the face of horrible news, it's a bullish sign.
Crux: OK... one more concept. Let's cover trading volume.
Hunt: That's a good one to end on. One more time, let's look at the enormous 2008 drop in shares of Potash. This situation can teach us another powerful technical concept...
The concept of trading volume.
Each day, the exchanges track the amount of trading volume in each stock index and each single security. This volume measures the amount of buying and selling activity present during the day... The higher the volume, the greater the amount of buying and selling activity.
Volume can serve as a useful tool because it allows you to track "elephants."
The stock market is dominated by large money managers... folks who run pension funds, insurance funds, mutual funds, and hedge funds. Many of these managers control billions of dollars in client assets... And when they decide to enter or exit a position, they can't do it over just a few days. They have to spread their buying over months. They even have to hire people whose main job is to determine the best way to plow big money into individual stocks.
These big money managers are the elephants in the stock market. They create the huge moves that become market trends. Remember, their portfolios can run well into the billions of dollars... So even a rich individual with a $5 million trading account is a mouse compared to these elephants.
You can track elephant behavior with trading volume.
I'm not going to say trading volume is the magic key to stock market profits. I do believe, however that there are two tried and true guidelines for using trading volume to increase your profitability.
One is a stock experiencing heavy trading volume on down days and light trading volume on up days is being sold by the big money. The elephant tracks are pointing in the direction of lower prices.
The phenomenon of "lots of trading volume on down days, not much trading volume on up days" is sometimes called "distribution," and it's especially useful when trying to determine the end of an uptrend. Let's take a look at Potash again. We're sticking with the same time period of mid-2008... when the big uptrend ended, and eventually turned into a big downtrend.
You'll see some black and red bars at the bottom of the chart below. These bars represent Potash's trading volume. Black bars represent days the stock advanced in price. Red bars represent days the stock declined in price. The taller the bar, the greater the volume.
Now note the tall "skyscraper" red bars in late July and early August (B). This is major selling pressure. Even worse, this selling pressure came on the great earnings report I just mentioned. Several elephants were fleeing Potash shares. And as you'll recall, Potash shares lost over 66% of their value soon after.
When you see a stock or stock index that was up big over the past few years start to exhibit this sort of "heavy down volume, light up volume" pattern of trading, it's a major warning sign the trend may be ending. A healthy uptrend enjoys big trading volume on buying days, not big trading volume on down days.
For our next guideline, we just flip things around and say a stock experiencing heavy trading volume on up days and light trading volume on down days is being purchased by the big money. The elephant tracks are pointing in the direction of higher prices.
The phenomenon of "lots of volume on up days, not much volume on down days" is sometimes called "accumulation," and it's especially useful when trying to determine the end of a downtrend. Perhaps the stock has fallen so much it has become an irresistible value... Or maybe the tough industry conditions hurting the business are over and large investors are taking notice.
For example, let's look at shares of Silver Wheaton from mid-2008 to early 2009.
Silver Wheaton is a company that finances early stage mining projects. It receives a slice of a project's revenue if it turns out to be a successful silver mine. Thus, the company tends to move up and down with the price of silver.
In late 2008, the price of silver crashed in response to the big 2008 credit crisis. The metal fell from $19 per ounce to $9 per ounce in less than five months. Silver Wheaton fared even worse... falling from $14 per share all the way down to $2.56. That's when the elephants started picking up shares...
Below is a chart of Silver Wheaton from mid-2008 to early 2009. Note the surge of buying volume in December, as represented by the series of tall dark bars (A).These are elephant tracks, and they signaled the end of Silver Wheaton's downtrend. The stock went on to gain more than 400% over the next 15 months.
Hunt: Once again... common sense technical analysis is no magic bullet. It's simply a way to help time your trades to ensure the biggest profits. Some traders have made incredible careers out of trading on advanced forms of technical analysis alone. But for most folks, it's best to "marry" basic technical concepts with fundamental measures of value. The two schools of thought can produce incredible investment results.
Sunday, 24 April 2011
Summary: "Common sense technical analysis" isn't about trying to predict where an asset will go based on it chart pattern. It's simply a collection of tools that allow an investor or trader to time his decisions based on how the fundamentals are affecting prices. Married with fundamental measures of value, it can increase investment and trading returns.
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