The General Market and It's Effect on Stocks Continued ...

The idea that an individual stock can be affected by the general market is not that hard to fathom. The whole idea of relative strength and weakness is based on this notion. Relative strength is generally defined as one stock or sector or market having strength as compared to another stock or sector or market. The opposite is true for relative weakness. What is many times overlooked is that the general market can easily affect your win/loss record with respect to trades.

For example, you can purchase a strong stock in a weak sector and a bearish market and see that trade fail; not because the stock is weak but because everything around it is. One of the most common failures is to buy a bullish breakout in a given issue only to see if fail because the general market is weak and getting weaker. Because this is so common, let's look at the possibilities that exist with respect to a stock, it's sector, the general market and the trends of each one. Here's is a matrix of all the possible outcomes that exist when you have three variables

Note that this matrix represents just one technical pattern; a bullish or a bearish breakout. The point to be taken is that you don't always want to trust just the pattern. In the case of a bearish breakout, for example, if the general market is a bull market as well as the sector that the stock resides in, then selling short the breakout might not be the right ticket. You have a higher failure rate in such as case than if the the bearish breakout were to occur with in a bear market with the stock sector that your stock is in also being in a bear market.

The next thing to note is that you should give more weight to the sector than the general market. From the matrix above, examine the following two entries more closely.

Note that in the above situation, you would want to proceed with a bullish breakout technical pattern (buy the breakout) even if the general market out look was bearish as long as the sector that the stock which is breaking out was itself bullish. On the other hand, if the sector that the stock is part of is bearish, you should be cautious about buying the breakout even if the general market was bullish. In other words, the sector is more important than the general market.

The last thing to note, is that I did not complicate this matrix with the three trend time frames that are possible. What I mean by this is that if consider that every stock, stock sector, and general market has three trends over three time frames; short, intermediate and long term. If you are looking to trade a stock short term, the rule of thumb is to compare that with the short term trend of the stock sector and the general market. If you are considering and intermediate term trade, then use intermediate term trends for the sector and the general market.

SUMMARY

In these two short articles, we have examine the notion that individual stocks are indeed effected by the general market as well as the stock sector that the stock belongs to. We also reviewed that there are three trends apparent in the general market as well as the sector and stocks individual and that they are not necessarily the same. Furthermore, we showed one example of a pattern that normally has a very high success rate (upward of 70%) potentially failing because the stock sector or the general market is tugging against it.

I leave it to you, the reader, to consider other patterns and what their individual success/failure matrix may look like.

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The General Market Does Affect Individual Stocks

There are many sayings on Wall Street and one of them is that a rising tide lifts all boats. What is really being said is that the general market makes a difference in what particular stocks do. If the general market is rising, then the majority of the individual stock issues will benefit from that rise. Conversely, if the general market is falling, then the opposite effect will be true to individual issues. Although the concept is simplistic, you can expand it to include some additional complexity and then use that knowledge to remove some of the frustrations associated with trading. A common frustration is to enter a trade in one or more stocks based on a successful past history of a given technical pattern only to see the trade(s) fail. Many times failures occur as a result of general market conditions that contribute to the failure, not because the stock that you are trading has a problem.

Sectors

To illustrate the point, we first have to understand that the market consist of many cross currents some of which are readily apparent, some which are not. At any given time there will be stocks going up and down. To a lay person, it can all look very confusing.

To try and make sense of it, consider that the general market consists of market subsets, if you will. Common groups of stocks that most people are familar with are technology stocks and the financials. These are two large and important groups of related stocks that, by virtue of their name, are commonly known and reasonably understood but there are many more. There are consumer stocks and the durable goods stocks as well as others like the internet and internet infrastructure. All told, there are many more groups of stocks than one would imagine. These groups of stocks are many times referred to as sectors.

Another point to be made is that many of these general stock sectors themselves can be subdivided into small sectors. For example, the technology sector consists of the semiconductors and bio-technology as well as additional sub-sectors like the software sector.

Now some sectors of the market generally move together while others move opposite. For example, usually when the oil sector stocks are moving higher that is typically not very good for the transportation stocks but when the semiconductor sector moves higher it generally helps the software sector.

Trends

Intertwined with the idea that there are many sectors that comprise the market there are several trends that are in place at any given point in time as well. Most market technicians identify three trends of Long, Intermediate, and Short Term (also known as Primary, Secondary, and Minor as defined by Edwards and Magee). These three trends apply to the market as a whole but more importantly, the trends also apply to each sector and, not to be ignored, they also apply to each individual stock as well (ETFs and other instruments also have trends).

So that we may talk the same language, a Short Term Trend (Minor) is defined as a trend that lasts as little as intraday and as long as a week or two, maybe three. An Intermediate Term Trend (Secondary) trend is a trend that lasts longer than three weeks an up to several months. A Long Term Trend is defined as a trend that lasts longer that several months.

Making Sense of it All

So, we now know that the market really is comprised of many sectors which themselves consist of sub-sectors and finally individual stocks. We also know that each stock has three trends occuring at any given time and that on a larger scale, each sub-sector also has three trends occuring as well. Taking it one step further, sectors likewise have three trends apparent and on the largest scale, markets themselves exhibit these same characteristics; namely three trends at all times.

Note that the three trends are not always in sync with each other. For example, a market can have a short term bullish trend while the intermediate term trend is bearish yet the long term trend is bullish. In fact, there can be as many as nine combinations of trends given that there are three trends and three possible directions a trend could be in (bullish, sideways, bearish).

... to be continued ...

The Bounce Trade (Final Thoughts)

By definition, the duration of a bounce trade is intended to be very short term. You are usually only looking for a one or two day move that allows you to either rake quick profits or to get out without losing much capital. If you are fortunate, you will catch a bounce that has more strength than expected and takes the stock back above (or below) the original peak. This is not common and you shouldn't enter the trade with that as the objective, but it does happen on occassion.

The Exit
To make a good bounce trade, you need to enter the trade with the expectation that you will be proved right or wrong within a day or two at most. By timing the entry, you have put the odds in your favor already, otherwise you wouldn't be in the trade. The key is to keep the odds in your favor. To do that, you have to execute your plan with precision and without second guessing your moves. This is most important with respect to your stop. When you enter the trade, you have determined what your defined risk is and based upon that risk and your potential reward you have decided the trade is worthwhile. If you do not exit at that defined risk point, then you have changed the equation. As a result, you must place a stop where your defined risk is and not waver if the price goes against you.

On the profit side, again this is a bounce play. The high percentage of bounce moves will never reach their previous highs (or lows) within the time frame you have for this trade. If, after having entered the trade, you find that the stock is moving strongly back to the direction of the trend, you may decide that taking profits at your defined profit area doesn't make sense. Even if it appears this way, you must take partial profits at a minimum. By taking partial profits (I usually take half), you guarantee yourself of a winning trade while allow the opportunity of a big win. You can bring your stop up to your entry point and allow the rest of the trade to run. If it comes back and stops you out, you make half of what was originally planned. If it keeps moving in the direction of the primary trend, you have the luxory of taking profits at a higher point. In most cases, however, you will not see the bounce accompanied by enough volume and strength to make you want to stick around and thus you will take profits at your defined exit point.

The more usual case is that neither your defined exit price (win or lose situation) isn't met yet your time frame for the trade is expiring. When that happens, as was the case in the example GLD, you have to close out the trade and take whatever loss or profit you have. It is inexcusable to stay in trade once it exceeds your predefined time frame unless it has performed far better than you expected. In all other cases, you must exit.

Summary

The bounce trade can be a very profitable trade given the amount of time that you are in the trade. It is centered upon the notion that prices eventually revert to their mean. When a stock (or any tradeable issue) has parabolically moved away from it's mean and then has recoiled quickly in the opposite direction, the bounce trade becomes and option. By timing entry and exit while religiously respecting the timeframe for the trade, the bounce trade can become another tool in your trading war chest.

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Bounce Trade ... follow through is key

To continue the discussion of the bounce trade, let's understand clearly what it is by looking at a chart. Here's the GLD chart that I'll refer to several times in the coming paragraphs.

A bounce trade is the attempt to catch a bounce. In this particular chart, the bounce is a function of the recoil from a parabolic rise back to a support region. The highs were set on 12/12/05 and recoil occurred straight back down till 12/16/05. The bounce trade is an attempt to catch the reflexive bounce that is expected to occur sending this issue back higher (bounce plays can be traded on either bullish recoils or bearish recoils as the principal is the same). The bounce trade is a very favorable trade from a risk/reward perspective and offers fast returns as well as outsized returns if the bounce ends up making higher highs (bullish bounce) or lower lows (bearish bounce).

The key factors in executing a successful bounce trade are:

1. To identify a parabolic blow off move as seen in this chart. That's the easy part.
2. Getting a good entry price (You have to understand when the recoil [in the chart above, the move back down to the $50 range] has ran it's course and a bounce is likely
3. To understand that the length of time you are in the trade is critical to the success of the trade. If you are in a bounce trade more than a couple days and it isn't already in your favor, you are probably going to fail on the trade

Identifying a Parabolic Move

The identification of a parabolic move is not very difficult. If you use Bollinger Bands, any time a traded issue pushes beyond the outer bands (up or down), a parabolic move is likely occurring. Momentum traders are on board and they are riding the wave so to speak. The problem is, all good things must come to an end and a parabolic move is no different.

Getting a Good Entry Price
Entry is critical on a bounce play. A bad entry can doom you to failure or a break even type trade at best. To get a good entry you have to be able to understand from looking at a chart, when the recoil is about done. There are two tell tale signs when measuring for an entry; percentage retrace/recoil and/or previous support zones, and volume signals.

Percentage Retrace/Recoil
You will find a lot of literature on the use of Fibonacci retracement targets and although I'm not a avid fan of the methods, I have to say that I do pay attention to the 3 key retracement targets of roughly 32%, 50% and 68%. The way you measure these retracements is from the breakout point to the parabolic type and then take the percentage (68% for example) and multiply it against that move and add it back to the initial breakout price. In the chart above the numbers are like this:

Breakout price = $47.72
Parabolic top = $53.76
Difference = $ 6.04
32% retrace is $1.93
50% retrace is $3.02
68% retrace is $4.10

So, if we watching the recoil and we see the price retrace to a 32% retrace level and volume is acting correctly (see volume tells below), then we might expect that to be the correct entry point. Similarly, you can use 50% or 68%. In the chart above, volume didn't act right until we reached the $50 area. If you take parabolic top price minus the 68% retrace price you get

($53.76 - $4.11) = $49.65

which turns out to be very close to where the recoil finished its descent. These measuring sticks are only approximations. If the parabolic move was great (as a percentage of the issues price), then it's more likely that the recoil will be 50% or even 68%.

Previous Support or Resistance Zones
It is important to consider previous support or resistance zones (if you are buying a retrace in a bullish trend, then you are looking for previous support while shorting a retrace in a bearish trend would call for resistance). In the GLD chart, there was weak previous support at the $50 area on the two highs in November but it was weak and therefore wasn't that useful in timing an entry. The better support in this chart would be back at that low of November 30th where the ETF traded at $49.06. In general, I prefer previous support and resistance to Fibonacci retracements.

Volume Signals

The key signal is volume. Volume should rise parabolically with price on the breakout move. Again, looking at the chart above, you can see that was the case with GLD moving from an average of 2 million shares to over 7 million on the day of the top. When the retrace occurs, you should expect the first couple of days that volume should continue heavy as traders have to reverse their positions. It's when volume begins to dry up (to get back to normal levels) that the recoil has likely ran it's course. Looking at the chart on GLD, you can see that on 12/16/05 and the following Monday (12/19/05), this is exactly what happened. That's the sign of a bounce play setup and the need for entry if you choose to play.

... to be continued.

The Art of the Bounce Trade

Last week I was looking to catch a bounce trade on the precious yellow metal both in the bullion and the stocks. We ended up catching a nice trade in the bullion then moved to the sideline when it failed at resistance booking some of the gains when it couldn't clear that 512.40 area basis the Feb contract. I wrote about it here.

We entered and stayed in the gold stocks last week until yesterday morning as the bullion tested that same resistance area and once again failed. As a result, I pulled all the gold stocks save TRE, on the notion that the bounce wasn't going to have enough juice and that you can't look a gift horse in the mouth.

Today we see the result with the bullion closing down more $10. I write this to discuss the concept of the bounce trade. The bounce trade (long or short) is simply the attempt to catch an extended market stretched too far and ready to bounce back. The recent move in gold bullion from just over 540 back to 497 in 4 days (basis the Feb contract) is an example of that. Most things in life revert to the mean. In other words, over time, price will revert back to the mean of the underlying trend. That's the principal behind Bollinger Bands, for example. If the current price is 1 or 2 standard deviations from the mean then it is popping out of the band that Bollinger defined.

When such an event happens, by definition you are looking to catch the swift and punishing reversion process. Because lots of money has been made on the spike, when it finally implodes those holding winning positions are all trying to squeeze through the same exit door. Add to that the traders who are try to catch the recoil. When that recoil runs it's course, then the bounce play is finally setup. The reason for chasing after bounce trades is that the risk/reward is usually favorable (if played right) and the profit potential for the time invested is much higher. Let's explore these thoughts further.

... to be continued ...