Posted By BillHeise on June 7, 2011

I was writing about my bets in the stock market this morning, and I wanted to tell you why I bet the way I did. But since it’s going to take me a couple days to get my article ready for publication, I wanted to make my bet public before the action of the stock market takes place.

I invested in an ETF called TNA. I bought it at 74.60. TNA is a triply-leveraged fund pegged to the Russel 2000 Index, meaning that if the Russell 2000 goes down $1, TNA will do go $3, and vice versa. By buying TNA, I am betting that the Russell 2000 Index will go up for the next couple days. Now, I have my son in an ETF called TZA, which is the inverse of TNA, meaning that if the Russell 2000 stocks go down, TZA will go up and vice versa. This is because I believe that the market is headed into a correction and that the bet I am making on TNA is a short-term investment. When I am done, I will go back to TZA.

At this moment (it is 7:45 AM CST), the stock is at 74.18, which means that I’m down about $47 and change. But I expect the stock to go up today. I put a selling price on it of 79.80. If things work out the way I hope they will–and this is investing; things don’t always work the way I think they will–then I will have captured a profit of $515.00.

Here’s why I think my bet will work. This is a technical analysis of the stock price, so some of this won’t sense to you if you are a fundamental investor. Nevertheless, this is my public declaration of faith in my investment. We’ll see at the end of the day whether I am right.

Chart 1

The first chart is of the blank market. As you can see, it is going down. But as you also know, past performance is no guarantee of future behavior. How can I know if the stock market will go up today, especially since I had the experience of watching it go down yesterday. This is where technical indicators come in handy.

Chart 2

This chart has my favorite technical indicators on it. These are the 10-day (white), 20-day (yellow), and 50-day (orange) moving averages; the 20,2,2 Bollinger Bands, the Commodity Channel Index. On a second panel, I have more lines, which I will treat in a moment.

Trend Lines

The moving averages are indicators of the behavior of stocks in the past, but they are also area where I have to watch my stocks’ behavior. For instance, look at my stock on my stock over the course of three days of May 18-20. On the 18th, the stock closed right around the 50-day line. The next day, the stock straddled the next highest line (the 10-day). On the 20th, it went back to the 50-day line.

Trend lines are important, and you can see by a cursory glance at Chart 2 just how often stocks touch base with trend lines. I have no idea why this works, and it is not always true that they work, but such clues–in poker we call them ‘tells’–take some of the guesswork out of reading the markets.

Bollinger Bands

These are the bands at the top and bottom of the trading range shaded in a bright blue. This is an indicator of volatility. Schwab explains them like this:

The Upper and Lower lines are placed n-standard deviations above and below the Mid line (simple moving average). Since standard deviations are a measure of volatility, the bands widen during volatile price action and contract when volatility drops. You can change the variables used in the calculation from the defaults of period=20 and n=2 standard deviations above and below.

Rather than two bands that are always an equal percentage away from the central average, Bollinger Bands expand and contract based on the standard deviation of the historical volatility of the price action.

My stock has been traveling along the bottom of the Bollinger Bands, indicating that we are in a down market.

The Commodity Channel Indicator (CCI)

Schwab defines this indicator thusly:

The Commodity Channel Index (CCI) measures the variation of a security’s price from its statistical mean. High values show that prices are unusually high compared to average prices whereas low values indicate that prices are unusually low. Contrary to its name, the CCI can be used effectively on any type of security, not just commodities.

I use it as a linear indicator of where we are in the visual Bollinger Band.

The Rubber Band Effect

I call the statistical indicators measures of the rubber band effect of stock prices. stocks sway off their mean, and when they do, the market exerts pressure on them to get back to the mean. This means that when a stock heads to the bottom of the Bollinger Band Range, it will spring back towards the mean.

It may not get there, but the farther away from the mean that a stock gets, the more pressure, which means that there is a a sort of logarithmic pressure exerted on stocks as they travel away from the mean.

More Than One Pressure Affects a Stock

There is more than one pressure that is exerting its influence on a stock. There is the general pressure of the market, which is weighing on stocks today. Then there is the sector a stock resides in. Lastly, there is the operation of the company itself. This was the downfall of Enron, who had been making up their numbers. But make no mistake, Enron was not a lone player in the stock market. Their inflated stock price inflated other companies. And when their stock fell, it dragged a lot of other companies down with it. This was not the fault of any individual company, and if you were holding shares of another energy company when Enron shares started to sink, I would hope you would have sold your shares in that company as well.

Stocks as a Leading Indicator

Sadly, that is not what most people were advising at the time. Buyers rushed in thinking they were getting a bargain in a stock that had been a sure-fire market leader for a year of more. When the news of Enron’s fraud broke, he stock went broke in a few weeks, but it had shown signs of breaking down before the news the fraud had struck.

Stocks are a leading indicator of future behavior. And how stock prices know what most of the analysts in the world don’t know is a mystery to me. This is the genesis of the stock trader’s saying that “Price is Truth.” You may want your stock price to go up; you may NEED it to go up; but if it goes down, then you are helpless to do anything about it. The cost of making an emotional decision can be catastrophic, so you better shore your decision with reasons which you can test against a stock price whose movement is out of your control or whether you will cut your losses. If you are wrong, your stock will sink or float without much help from you.

Chart 3

Here’s my last chart of the stock market. This is the chart that I use to make my decisions about where my stock is heading. I have left a bit of the price action visible for you, but I prefer to operate on this chart without the price action visible, since the volatile price action is minimized. For instance, you might have noticed that the stock tested the Bollinger bottom earlier in the day, but it’s now hovering above 75.00.

This chart has several features, just like the primary price chart.

MACD 9 day line (blue)

This line is a long term indicator that I use when looking at really long term trends of a year or more. It has been falling since the market top of 5/2/2011 (not pictured in my charts)

MACD Signal Line (bright green) and the MACDh Histogram

The MACD Signal line is expressed on my chart by a bright green line, known as the signal line. This line is of major importance in my estimation of where the stock will be headed today. When measured against the MACD Line, it gives me a signal. When the Signal Line is above the MACD Line, then we are in positive territory, as you can see by the visual representation of the MACDh Historgram, pictured here as a series of red bars. As you can clearly see, the one day when the MACD Signal Line was above the MACD Line, the chart measured a positive rating.

The thing about the MACDh Histogram chart that you will notice is how stock prices, which may look erratic or unpredictable to the naked eye come into closer view when looked at through the lens of charts. Even in a disastrous reversal like we had on 6/1/2011, the MACDh Historgram reversed itself and started to go down. And it continued to go down for another three days.

Stochastic Oscillators (red, yellow)

To understand why I decided to sell my TZA, which I rode down for the last few days for a profit, you need to understand the Stochastic Oscillators, which are pictured here as yellow and red lines. These indicate the over- of under-sold status of a stock. Yesterday, my stock had reached a low on the oscillator scale. Like the statistical indicators of the Bollinger Bands, I strongly suspect that the stock will spring back.

Why I Made My Bet Yesterday

Stocks are like mice in a maze. They can break out if they are really determined. Yesterday, for instance, my stock (its really an ETF) closed below its Bollinger Band lower limit. The last time it did that (3/15/2011), it raced back for a bull run that lasted until 4/6/2011. It went up from $70.50 to $91.00, for a price increase of just under 30%. Not bad.

My point is that it is uncomfortable for the mice when they are out of their cages, and they want to get back in. My stock charts enable me to look at the market with a dispassionate eye. My charts were telling me that one stock (TZA) was over bought, while the inverse was over sold (TNA). So I switched out of my over bought stock at a profit (TZA) and went into my other stock (TNA) on the basis that it is ready to make a move to the upside.

Of course I couldn’t ever be completely sure. Since I started writing, my stock has been as low as $73.48, testing the Bollinger Line again. Had I panicked and sold–something I am likely to do–I would have been out another $125.00. Fortunately, I’m made of stronger stuff.

I will not know today whether I have bet correctly of not. I will have to wait until the market begins its day somewhere in the middle and doesn’t test the bottom of the Bollinger Line. Hopefully, on that day, my stock will hit my sell point, which is currently at the 10-day line. Today, that’s close to $80.00.

Timing Markets

The secret to timing the market is to take a good look at the price sheet, since price is the final measure of truth. But I add to that model a series of secondary indicators which are designed to give me a a smoother picture of the market that I can trade on. I divide my model into Primary and secondary indicators.

Primary Indicators

MACDh Histogram: This is my favorite indicator. Used alone it is weak, but when used with the Bollinger Bands it represents a good indication of of the short term direction of the stock market.

My buying rules are these: buy a stock when it is over sold at the lower end of the Bolligner Band range. Sell in a down market like the one we’re in when it gets to the middle of the range. After all, we are not seeing stocks climbing back to new highs in the current market. In a bull market, I would let them run up and pay more attention to the secondary oscillators.

Secondary Indicators

When I need to find points at which I want to sell my upticking ETF (TNA), I rely on the 10- or 20- or 50-day lines. I sold my TNA stock last week when ir reached the 10-day line, and was dismayed when it went on to trade in a range between the 20- and 50-day range for a day and then broke out beyond that before crashing in a single day through all three lines. I made my profit, and was happy. I got back in and rode the stock down until yesterday.

I use the CCI to confirm my sense of how the trend is shaping up. As you can see, the CCI indicates that stocks have lately been going down tend to rise only to the mid-range. They are not moving up to the high ranges of the bull marke, indicating that we are in a bear market.

I am not sure of myself as it may seem to you who are reading this. This is my rational explanation of an emotional process. I discussed my reasons for reacting with reason and not emotion in my Poker Tales.

But it is much harder than it looks to those who stand outside looking in. When I started writing this paragraph (5 minutes ago) my stock was up about to about $75.15, representing a profit of $50.00. Since then, it has fallen below the price I paid for it to $74.30, for a loss of $35.00. After the week is over, you will be able to judge me a fool or a hero. Until that time, we wait on the price to tell me whether I made the correct bet.

Categories: Economics
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