Stockscores.com Perspectives for the week ending May 8, 2010

In this week’s issue:

Weekly Commentary
Strategy of the Week

As a trader, I prefer to focus on the stocks that are detached from the overall market. Most stocks, most of the time, will move with the market’s gyrations. However, when you can find stocks that are trading with abnormal volume and price volatility, you have an opportunity to beat the market. These stocks are trading on their own story and not with the mood of stocks in general.

But what do you do when the overall market is abnormal like it was last week? When the stock market makes very abnormal price moves on very heavy volume, it is highly unlikely that you will find stocks that are not influenced by the market’s direction. If the market drops 500, expect just about every stock to fall with it.

When the market is abnormal, I trade the market. The easiest way to do that is to focus on the Exchange Traded Funds that represent different market indexes. At the most basic level, you have the SPY, DIA, QQQQ and T.XIU which represent the four major North American stock indexes (S&P 500, Dow 30, Nasdaq 100 and TSX 60).

Since these ETFs move much slower than stocks (because they represent a large basket of stocks), you can also consider leveraged ETFs like QID, QLD, SDS, SSO, DDM and DXD. In Canada, T.HXD and T.HXU. However, exercise caution when trading these leveraged ETFs because they have to be rebalanced at the end of each trading day so that they will reflect a 2 to 1 leverage on the overall market. Over time, that rebalancing erodes value if the position is trading against you. I only consider these ETFs for day or swing trading.

An easy way to trade Gold is through the GLD ETF or with leverage by trading T.HGD or T.HGU (one is a short gold fund, the other long). Oil can be traded through the USO or with T.HOD or T.HOU. These TSX listed ETFs that start with an H are leveraged funds in the Horizon Beta Pro family.

It is also possible to simply bet on expected price volatility. In the options market, an important determinant of option prices is price volatility; the more price volatility is expected to be, the higher the price of the option. There is an index called the VIX that is based on this implied price volatility of options and you can trade an ETF based on this, it trades with the symbol VXX. I recommended it on April 27th, it closed Friday up 43% in that very short time period.

When trading these instruments, remember a simple rule. You make money by predicting what will happen, not by reacting to what has happened.

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Buying the VXX today is not a good trade since it has already gone up a lot. You have to enter these when they are showing signs that they are starting to go up. If the trade looks like a sure thing, it probably is not. The best trades are the ones that are hard to do, one where you feel you are taking a risk. I like to say, you have to buy the risk, not the reward.

Most days, I would never trade the overall market. There was a time when I traded the S&P 500 Futures but I never did great at it. This is a very efficiently priced market that is hard to make money at most of the time. However, when the overall market becomes abnormal, it is a great place to trade. The liquidity is amazing and the price moves can be very profitable.

Looking back at the last year, there were only about 10 days that I would consider the general market to be abnormal enough to trade. Interestingly, most of those days were sharp downward moves. This points to another rule to put in your book; trade stocks on the way up, trade the market on the way down.

The market has been very crazy this week, but the signs of weakness were there. First Goldman scared the market and we broke the 60 day, 60 minute chart upward trend line. Then concerns about European debt started to grab attention and we broke the upward trend line on the daily chart. Now, you have a lack of confidence in the trading systems as a result of the 1000 Dow point drop on Thursday and we are breaking a more important long term trend line.

As long as you listen to the market and go to where the abnormal activity is, you can do well in any environment.

The past few days have been unusual, to say the least. In 20 years of trading, I have never seen anything like the price drop that occurred briefly on Thursday. The computers took over and they did irrational things. Hopefully it serves to wake up regulators who, I believe, have let computers play too big a role. Technology has got to a point where, in the time it takes to tap your finger on the table, 10,000 to 20,000 trades can be executed by one algorithmic trader. That is a difficult thing to control and needs to be changed.

Trading the market over the past few days has only been appropriate for those who can watch the market very closely, and even they would have had trouble on Thursday. Until the market itself goes back to normal trading volumes and price volatility, I recommend sitting on the sidelines.

If you are an active trader, there are some great trading opportunities, particularly with some of the ETFs that benefit from the volatility. Nimble traders should enjoy these instruments and the rest should wait patiently for the dust to settle. No new position trading features this week.

References
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Tyler Bollhorn started trading the stock market with $3,000 in capital, some borrowed from his credit card, when he was just 19 years old. As he worked through the Business program at the University of Calgary, he constantly followed the market and traded stocks. Upon graduation, he could not shake his addiction to the market, and so he continued to trade and study the market by day, while working as a DJ at night. From his 600 square foot basement suite that he shared with his brother, Mr. Bollhorn pursued his dream of making his living buying and selling stocks.

Much of Mr Bollhorn’s work was pioneering, so he had to create his own tools to identify opportunities. With a vision of making the research process simpler and more effective, he created the Stockscores Approach to trading, and partnered with Stockgroup in the creation of the Stockscores.com web site. He found that he enjoyed teaching others how the market works almost as much as trading it, and he has since taught hundreds of traders how to apply the Stockscores Approach to the market.

Disclaimer
This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don’t consider buying or selling any stock without conducting your own due diligence.