The idea of selling in May and going away is an old Wall Street adage that’s based on the seasonality of summer stock prices. Historically, May through September tends to be the weakest period of stock performance — and that fact is fresh in recent memory. In 2010, the S&P fell 8.2% in May. In 2011, Mr. Market fell more than 17% during the summer months.

But don’t get too startled by the numbers. Two years does not a market rule make…

Think about it: if everyone decided to blindly sell in May and go away until the Fall, then June would become a pretty good time to buy — stocks would become so undervalued that opportunistic buyers could pick up bargains by the fistful. And a quick Google search shows just how popular this “market rule” is; a quick search of the phrase returns 54.7 million hits.

In reality, “sell in May and go away” is just another one of those clichés that doesn’t mean a whole lot without context. It’s like telling someone to “buy low and sell high” or “diversify”; unless you know specific steps to do those things correctly, it’s worthless.

In the context of a bearish market, sell in May and go away can be a bit of added information that the drop is going to be especially painful. But in the context we’re in now (a correction after a bull run), it’s meaningless…

To show you that context, I want to share three charts that add some important color to what’s going on in the S&P 500.

The first is a look at the S&P’s advance-decline line, a measure of market strength:

Taking a look at the indicator, it’s clear that the uptrend in the A-D line is still in force. In a nutshell, that indicates that a larger number of stocks are still participating in this rally. So even though the S&P has corrected for a few weeks, the underpinnings of the market remain strong.

Next up is volatility, as measured by the Bollinger Bandwidth of the S&P 500:

In case you’re not familiar, Bollinger Bands are statistical measures of how volatile stocks are right now. When the bandwidth reading gets higher, it tells us that stocks are “risky” right now; when it shrinks, the market is relatively smoother. With the bandwidth reading trending towards 52-week lows right now, we’ve got a good indication that volatility readings are due for a spike.

In other words, if that S&P 1,430 target is correct, it could come quickly…

But that leads to another important question: just how high can stocks safely go right now? Taking a look at historical levels, the answer may surprise you. This chart from Bloomberg tells an interesting story:

The chart measures the value of the S&P 500 as a percentage of the gross domestic product of the United States. In other words, it’s a look at how valuable [predominantly] U.S. companies are versus the value of all of the trade that takes place within U.S. borders.

Historically, stock values have eclipsed GDP — barring the massive price swings of 2008, the market hasn’t been holding at these “cheap” levels for the better part of a decade. Typically, I’m not a huge fan of platitudes like “stocks are cheap”, but in this case, it does do a good job of showing us what’s going on in the broad market.

From there, we’re clear to apply solid technical analysis to figure out which stocks investors think are cheap right now, and pounce when high probability trades pass through our crosshairs.

The bottom line is this: don’t sell in May and go away. Instead, look for the trades with big targets on their backs. Technical traders should be looking for breakouts and bounces off of support. Fundamental investors should be scooping up the bargain names. Buying in May and deciding to stay could fuel your gains for the rest of the summer…

Cheers,

Jonas Elmerraji
for The Penny Sleuth

Selling in May and Going Away was originally featured in the Penny Sleuth.

Absolutely nothing.

But you wouldn’t know it to look at the Wall Street Journal on Friday…

After all, the lotto was featured as a major economic story in the WSJ this weekend. All told, I counted seven different lottery articles on the Wall Street Journal’s homepage.

Seven!

While I know yesterday was April Fool’s day, I only wish I were joking about that part. Of course, WSJ wasn’t the sole offender. You can also read about the lotto in CNN Money and Bloomberg. The absurdity is a little easier to spot because the lotto story is completely asinine. But the media does a much better job of disguising their bogus market attribution most days of the week.

For 95% of investors, major media outlets are the go-to place for understanding why the market’s moving on any given day. We’ve been programmed to turn to the news to understand why something’s happening. But today, I want you to see why it pays to be one of the 5% of investors that ignores the noise.

The “Mega Millions connection” isn’t the worst offender — it’s only the most obvious one.

Here’s another:

“Investors flocked to consumer-oriented shares after data showed U.S. consumer spending rose by the most in seven months in February, even as personal income increased only modestly,” says an article that ran in Reuters on Friday.

How much “flocking” were those investors doing? They added 0.4% to the S&P Consumer Discretionary Sector Index…

As a trader, you’ve got to ask yourself whether investors were flocking to consumer stocks, or whether a Reuters journalist was looking for some reason to explain Mr. Market’s unimpressive trading. My guess is that example is a case of the latter…

I’ve said for a long time that Wall Street has an attribution problem. Investors see a big pop in stocks, and they look for the nearest headline as a reason for the move. It’s important to break from that frame of thinking if you want to find success in stocks.

More often than not, the headline being touted by Wall Street doesn’t matter…

To be sure, sometimes news really does move stocks. More often, a news blip is one of a thousand inputs that are pushing stock prices in a certain direction. For every investor who buys consumer stocks on marginally changed consumer spending data, another is buying because he thinks they’re cheap, and another is selling on a tip. But when real market moving news hits, you know it.

That’s why I rely on technical analysis…

At its core, technical analysis is the study of how supply and demand is impacting stocks in the marketplace — after all, supply and demand are the only two factors that actually impact a stock’s price. I don’t care what’s causing the supply or demand forces (it could be a news story or earnings improvements — heck, or even the $80 jillion Mega Millions drawing on the planet Jupiter).

All I care about is where those pockets of supply and demand are located, and how they can cue us to high probability trades.

If you’re new to technical analysis, I’d strongly recommend taking a look at the Penny Sleuth’s Research Reports section — there, you’ll find primers on putting technical analysis to work for your portfolio. It’s a starting point to help you ignore the daily noise — and focus solely on factors that actually move the market.

Happy trading,

Jonas Elmerraji
for The Penny Sleuth

What the Mega Millions Means for Stocks was originally featured in the Penny Sleuth.

Thumbing through the financial pages of any newspaper, I could pick out a half-dozen conflicting, convoluted, or crazy market predictions for the second half of 2011. And none of it is doing much good for individual investors.

When the volume of noise on Wall Street gets too high, it makes sense to tune it out and take a look at the only data points that matter. I’m talking about the technical charts.

Today, I want to show you why the S&P 500 Index could be in store for a rally this month, and what it means for your own portfolio…

First though, a bit of background. As far as I’m concerned, the S&P 500 is the most important index for stock investors to watch. It’s made up of the 500 biggest stocks on the market – so it’s a pretty good proxy for the stock market as a whole. Here’s a look at what the S&P 500 has been doing for the last year:

Even if you’re not an experienced technical analyst, you can tell a couple of things about this chart right off the bat. For starters, the market has moved significantly higher in the last year. And the market has hit a sort of “ceiling” ever since the middle of February.

That ceiling sits at around 1,350…

With the exception of a few trading days in early May, the S&P 500 hasn’t been able to sustain a climb above 1,350 in 2011. As a result, 1,350 is a price level that technical analysts refer to as a resistance level. It’s a price where supply of stocks exceeds demand.

But resistance levels do eventually break – and when they do, rallies can ensue.

Since the S&P 500 is such a significant barometer for the broad market, investors can benefit in a big way by holding stocks when that sort of breakout occurs. The trick is spotting when.

Here’s a zoomed-in look at what’s going on in the S&P right now:

The index is showing us a technical formation known as an inverse head and shoulders pattern. It’s a setup that demonstrates exhaustion among sellers. Most importantly, it gives buyers the signal when it’s time to buy.

You’ll want to keep a close eye on the resistance level in the S&P 500 right now. If the index pushes above 1,350 (and holds there), then we could see a meaningful rally in the S&P.

Remember that this isn’t the first time the index has tested 1,350. Any sort of breakout in the index will need to be significant – not just a flirtation with 1,351. That said, traders shouldn’t underestimate the significance of a push above 1,350 – or the impact it could have on stock prices to end the year.

Cheers,

Jonas Elmerraji
Penny Sleuth

Chart Smarts: Why July Could Bring a Rally in the S&P 500 was originally featured in the Penny Sleuth.

Yesterday the market’s latest IPO, Pandora Media (NYSE:P) rallied double digits. Back in May, LinkedIn’s IPO (NYSE:LNKD) rallied 47% in its first day of trading.

Again, to most people, double-digit gains in a day seem pretty impressive.

But I recommend you stay out of the IPO market… until it flashes the “buy signal” that I’ll show you in this alert. I’ll show you the buy signal in a moment.

But first, here’s why I recommend you stay out…

Despite the red hot start, if you bought shares of LinkedIn the day it started trading, you could be down more than 38% on the year – shares have been moving lower steadily since.

Likewise, if you bought Pandora at the height of Wednesday’s trading, you could be sitting on losses of 30%. Here’s another chart:

So much for buying a “hot IPO,” eh?

You see, the current slew of IPOs (and yes, there are many more in the pipeline) is predicated on hype and promise, not cold hard numbers. While that may fly in a more buoyant market, it’s a toxic situation given the weakness stocks have seen since the beginning of June. It’s something that I wrote about following LinkedIn’s IPO – hopefully you weren’t suckered into the new, hyped names that have started trading since.

All of that said, there is a way to profit in spite of weakness in the IPO market…

In fact, as I see it, the key is finding technically relevant levels on newly-public names. Let me show you a real-world example:

Trading IPO Names For Fun and Profit

Back in late 2010, Tesla Motors (NASDAQ:TSLA) was a lot like LNKD. Shares had gone public in late June of last year, only to peak on their first trading week and move lower over the next few months. But on October 20, 2011, my Penny Stock Fortunes colleague Greg Guenthner and I recommended buying shares – since then the position has rallied more than 40%.

So, what was the key to cashing in IPO gains on Tesla?

The first factor was quality. Even though Tesla’s fundamentals were nascent, the stock was offering a muted valuation relative to its potential. Still, investor exuberance can overpower a stock’s “story” any day of the week – to get the timing right, the stock still had to be a technically relevant buy. Take a look at its chart:

Source: Bloomberg

Even though shares of Tesla had only been public for a few months, the company’s chart told us a wealth about how the market was pricing this stock. After peaking, shares sold off to the $15 level, setting ultimate support. After that, shares carved out two more significant support levels (the thick white and red horizontal lines in the chart above) that offered us a good buying target and stop loss target respectively.

Simply put, support can be thought of as a “price floor” for shares of a stock. They’re levels where shares have found an intermediate bottom – that low point indicates that there’s a glut of demand for shares at that price.

In practical terms, a support level is the price where investors start to think, “Hey… that stock looks cheap!”

Support levels are often the lowest price a stock trades at (at least for a while) not surprisingly, then, investors want to buy shares close to support.

In short, a bounce off of support lines is the “buy signal” you should wait for when looking at these IPOs.

Even though buying Tesla was a long-term position, the factor that made this trade successful was the fact that we picked up shares when probabilities highly favored the demand side of the equation. That’s exactly the scenario that you should be shooting for on any IPO trade regardless of your time horizon.

From a technical analysis standpoint, LinkedIn is starting to look like Tesla did – but it’s still too soon to tell whether it will make a good buy. Shares still have yet to set a meaningful support level.

My recommendation: give the latest batch of IPOs a few months… wait for the “buy signal” to flash… and then look for a chance to buy just above support.

Sincerely,

Jonas Elmerraji
Penny Sleuth

Chart Smarts: Squeezing Gains From This Toxic IPO Market was originally featured in the Penny Sleuth.

Dear Penny Sleuther,

Although market volume is a crucial piece of investment information, the majority of the public is ignorant of it. Fundamental analysts do not consider volume, whereas technical analysts underutilize it. In my new book Investing with Volume Analysis I discuss how volume provides essential information in two critical ways: by indicating a price change before it happens and by helping the technician interpret the meaning of a price change as it happens.

Here’s a look at how you can harness the power of “the force” to predict and interpret price action in small-cap stocks…

Volume Leads Price

Although practitioners of technical analysis and academia have often been at odds, volume information is one area where they tend to largely agree. Volume can provide essential information by indicating a price change before it happens.

The message is extremely telling, particularly when the volume reaches extreme levels. During such times, volume offers far superior information than price alone could ever provide. Authors Gervails, Kaniel, and Minglegrin of “The High Volume Return Premium,” a white paper from The Rodney L. White Center for Financial Research of The Wharton School, University of Pennsylvania state, “We find that individual stocks whose trading activity is unusually large (small) over periods of a day or week, as measured by trading volume during those periods, tend to experience large (small) subsequent returns.” The researchers further state, “A stock that experiences unusually large trading activity over a particular day or a week is expected to subsequently appreciate.”

The testing results of their 33-year study comparing stocks that experience relatively high volume surges compared to normal and low-volume stocks is illustrated in the chart below. Similar conclusions were confirmed by Kaniel, Li, and Starks of the University of Texas. Their research paper, “The High Volume Return Premium and the Investor Recognition Hypothesis: International Evidence and Determinants,” concludes:

“We study the existence and magnitude of the high-volume return premium across equity markets in 41 different countries and find that the premium is a strikingly pervasive global phenomenon. We find evidence that the premium is a significant presence in almost all developed markets and in a number of emerging markets as well.”

Source: “The High Volume Return Premium,”
The Wharton School University, Pennsylvania

Volume Interprets Price

The second critical way in which volume provides information is by helping traders interpret price.

Volume enables the analyst to interpret the meaning of price through the lens of the corresponding volume. The authors Blume, Easley, and O’Hara (1994) reported in “Market Statistics and Technical Analysis: The Role of Volume,” in the Journal of Finance, “volume provides information on information quality that cannot be produced by the price static. These researchers demonstrate how volume, information precision, and price movements relate, as well as how sequences of volume and prices can be informative. Moreover, they also show that traders who use information contained in market statistics do better than those trades who do not. Thus, technical analysis arises as a natural component of the agents learning process.”

However, price alone represents the vast majority of the work within technical analysis. As such, this book gives volume the significance it is due as an essential element of investment analysis.

Yet doing so without also discussing price is also insufficient. Volume cannot be properly understood without price any more than price can be adequately assessed without volume. Independently, both price and volume convey only vague market information. However, when examined together, they provide indications of supply and demand that neither could provide independently.

Ying (1966), in his groundbreaking work on price-volume correlations, stated, “Price and volume of sales in the stock market are joint products of a single market mechanism; any model that attempts to isolate prices from volumes or vice versa will inevitably yield incomplete if not erroneous results.”

From my research I have found that volume is a very valuable variable in stock analysis and its effects are more significant upon smaller capitalized overlooked securities. As such, I believe this translates well for the penny stock investor looking to employ volume analysis concepts into their own research efforts.

Sincerely,
Buff Pelz Dormeier, CMT
Penny Sleuth

April 15, 2011

Editor’s Endnote: To learn more about integrating volume into your trading, Buff’s new book, Investing with Volume Analysis, provides an accessible in-depth view of this essential technical metric. To grab your own copy, and profit from the hidden forces behind market moves, just click here…

Excerpted with permission from Investing with Volume Analysis: Identify, Follow, and Profit from Trends by Buff Pelz Dormeier (FT Press; 0137085508).

Use “The Force”: Harnessing Volume to Predict and Understand Stock Prices was originally featured in the Penny Sleuth.

Historically, when stocks fail to produce gains, investors have turned to “safer” alternatives like gold or silver, bonds, and money market funds. But safety is a relative term – while these alternative asset classes do typically outperform bear markets for stocks, it’s a big mistake to think of metals like gold or silver as a safe alternative to the broad market.

That’s because the volatility on metals is often as high (or higher than) volatility in stocks. Silver, as measured by the iShares Silver ETF (NYSE:SLV) has rallied more than 115% in the last year – that’s far from “safe”.

Of course, high volatility in metals isn’t a bad thing. In fact, it’s a good thing for traders looking for tactical buying opportunities.

So, how do you use that volatility to your advantage? One incredibly effective strategy is to look for high-probability technical trading opportunities in metals, then turn to junior mining stocks as a means of magnifying a move in the metal. Because bullish breakout potential is forming in heavily traded metals like gold and silver right now, it makes sense to pay close attention to what’s going on in this market.

Want to see what I mean? Take a look at the charts of gold and silver futures below:

These charts show both metals nearing strong resistance levels (the horizontal grey lines). A breakout above those levels suggests that precious metal bulls have absorbed excess supply of futures contracts, and that the spot price of gold and silver are free to move higher.

And because small-cap mining stocks have share prices that are tied very closely to the price of the metals they mine, a breakout in either metal presents an excellent buying opportunity for junior mining stocks…

Here’s a rundown of three of the precious metals stocks that present attractive technicals right now:

• Kimber Resources (AMEX:KBX): This gold stock is seeing a strong resistance level at $1.80. Traders should wait for a break above that level before going long.

• Mag Silver Corp (AMEX:MVG): An ascending triangle setup in Mag Silver presents a potential buy on a move above $13. Until then, this isn’t a high-probability trade.

• International Tower Hill Mines (AMEX:THM): Here’s another gold stock that’s seeing strong resistance right now. In this case, our upside barrier is right around $10.50. If THM can sustain a move above that price, shares should be able to move significantly higher.

Keep in mind that I wouldn’t recommend buying any of these three stocks at this time – instead, they’re stocks that could make good buys if they can manage a move above their respective resistance levels.

Happy Trading,

Jonas Elmerraji
Penny Sleuth

Why Penny Stock Investors Should be Watching for a Breakout in Metals was originally featured in the Penny Sleuth.

Today, we’re going to fill that void by looking at head-and-shoulders trading tactics through the lens of a real-world trade that gave my Penny Momentum Trader readers a chance to book 51% gains in just five days. Here’s everything you need to know to do the same…

It’s important not to get too caught up with patterns. Ultimately, patterns are just an easy way to describe significant technical price action in stocks – they’re not an end unto themselves. That’s evident in the fact that an estimated 90% of traders lose money. But by applying trading rules to patterns, that number can shrink significantly.

Simply put, a head-and-shoulders pattern is a bearish formation that’s made up of three “peaks” in a stock’s price action – one large peak (the head), and two smaller peaks on either side (the shoulders). It signals a top in a stock. Remember, though, it’s not the pattern that’s important, it’s what the pattern represents: a head-and-shoulders is a good indication of exhaustion in a stock’s share price – as trading volume declines in the head, and prices fail to reach previous highs in the right shoulder, the market’s giving serious indications that bullish powers are waning.

Statistically, the head-and-shoulders pattern is worth watching. An academic study conducted by the Federal Reserve Board of New York suggests that the results of 10,000 computer simulated head-and-shoulders trades resulted in “profits [that] would have been both statistically and economically significant.”

Like I said before, though, the toughest part of successfully trading a head-and-shoulders pattern isn’t in identifying it in a stock chart; instead, it’s the challenge of picking the right entry and exit points.

For a real world example, let’s take a look at Endeavour Silver Corp. (AMEX: EXK), a small-cap silver company that I recommended to my Penny Momentum Trader readers back on March 2. Shares of EXK had been forming an attractive inverted head-and-shoulders pattern, an upside down head-and-shoulders that’s a bullish setup.

Take a look at the chart below for a visual description of this stock’s price action:

The “buy” trigger for EXK came on the first day that broke the stock’s “neckline” (also sometimes called shoulder level), the line that connects the small peaks on either side of the shoulders. It’s not enough that shares broke above the neckline, however – what traders should be looking for is a confirmed breakout. That means conclusive evidence that the push higher is more than just a minor intraday whipsaw.

Good confirmation includes a close above the neckline, followed by an open above it the next day. More conservative traders would be wise to wait for two consecutive opens above the neckline, just keep in mind that your extra margin of safety comes at a cost of lost potential gains.

The key to a successful exit on the trade comes from setting a realistic target price. In a head-and-shoulders pattern, the general rule for determining a target price comes from measuring the distance from the peak (or trough) of the head to the neckline. Then, measure that same distance on the other side of the neckline – that’s your price target.

For us, we opted to close out the trade on the first trading day that breached our target price (the dotted red line in the chart above). By doing that, we actually managed to capture near-maximum gains – as you can see from the chart, prices reversed just days after we sold.

Ultimately, readers who bought the option I recommended were able to cash out 51% gains in just 5 trading days.

By setting your trigger buy price (at the neckline) and your target price ahead of time, you’ll be able to take emotion out of your trades, define your potential gains ahead of time, and statistically improve the percentage of winning trades in your portfolio.

Obviously, there can be a steep learning curve to technical trading – but with practice, it can become as comfortable to you as any other investment method. When just getting started, I’d always recommend using paper trading before you sink real cash behind any new strategy.

Cheers,
Jonas Elmerraji
Penny Sleuth

March 18, 2011

Chart Smarts: How to Trade a Head-and-Shoulders for 51% Gains was originally featured in the Penny Sleuth.

Before you begin thinking about where to go from here, it’s important to take a critical look at the market at large. Things aren’t pretty right now, but that doesn’t mean you should sit on your hands. Now is the time for a critical look at your portfolio. In short, it’s time to get defensive. That’s why I’m detailing three steps you need to take to save your portfolio from a correcting stock market.

1.    If you have a weak hand, now is the time to fold. Get your weak, speculative stocks off the table. You shouldn’t get bogged down in the stories of these stocks. If these speculative names are falling with the market and breaking support, sell to preserve your capital. Remember, selling now doesn’t mean that you can’t revisit the stock at a later date. Cash is a viable position, and sitting on the sidelines to see where your speculative picks end up when the dust settles wouldn’t be a bad move.

2.    Check the market for recent misses. Look over your watch lists from the past few months. In these pages, you probably have the names of several potential trades that “got away” from you. Now, thanks to the correction, you might have the chance to buy one or more of these stocks at a more reasonable price.

This bit of advice comes with a caveat: don’t rush a new trade while the market is correcting—and don’t buy stocks that are in the middle of a free-fall. Calling a bottom can be difficult—and dangerous. Instead, look for names that have corrected, are on or above support, and are showing signs of life.

3.    The trend is still your friend. Here’s a helpful take on momentum versus trend. It comes from Jeff deGraaf, a highly respected technical analyst and alumnus of Lehman and Merrill Lynch. Recently, deGraaf detailed an important distinction between trend and momentum that I want to highlight for you.

When the market has momentum, deGraaf says, you need to participate. In other words, strong market movement should dictate your buying. On the other hand, deGraaf observes that trend is more flexible, allowing you the luxury to wait for good entry points.

Right now, it’s obvious that momentum is not dictating a strong market move to the upside. But it’s also important to remember that the primary trend is not yet broken. Your best bet is to disregard momentum trades in favor of trending stocks to add to your list of trade candidates.

Lately, the market has been opening a door one day, only to slam it shut the next. That’s why you need to be extra careful. You don’t want commissions eating your accounts because you get stopped out of trades every day. If you follow my three tips, you should be in a much better position to profit when the market finds support.

Sincerely,
Greg Guenthner
Penny Sleuth

March 16, 2011

3 Important Steps That Could Save Your Portfolio was originally featured in the Penny Sleuth.

Don’t think that anyone – present company included – is immune from the frustrations of seeing portfolio positions dip or watching as the S&P 500 sells off for yet another consecutive day. But stock market frustration only becomes a real problem when it starts to interfere with your decision-making process. Now more than ever, it’s crucial to follow your preset trading rules, and stick to the system.

Whenever you enter a trade, you should go in thinking about your exit plan from the start, whether the stock performs as expected or it doesn’t. Those two price levels need to be dictated by predetermined analysis, not by how we feel about the market; when used to guide your trading, they can spare you from premature selling.

It’s all about having perspective. With the right context for a stock’s move, suddenly sell-offs aren’t panic inducing. Today, I want to share some of the market context that my Penny Momentum Trader readers have been benefiting from:

I’ve been putting a lot of emphasis on the technical significance of the 1,300 level in the S&P 500 since late 2010. So, can you guess where last week’s sell-off stopped?

That’s right. Despite some flirtations in the mid-1,290s for around 20 minutes on Thursday, the S&P held up above our technical support level nearly perfectly. Remember, it’s important that the market is following our technical cues – it means that last week’s price action is probably just a healthy correction, and that our cautiously bullish outlook for the near-term continues to hold. Even though we were able to pin the market’s “floor” within a few points, I want to stress for newer members that we’re not in the business of making predictions here. As technical traders, we’re focused on contingent expectations – a framework for trading that’s based on if/then rules.

If the market stays above 1,300, we’ll continue to be cautiously bullish…

So that said, what would we like to see as we enter the first week of March? Ideally, we’ll get a bit of sideways consolidation in the S&P 500 this week as the market cools off from the rollercoaster ride we’ve just endured.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

March 1, 2011

Avoid Serious Losses By Following the Rules was originally featured in the Penny Sleuth.

The year of the American Contagion; the year of chickens coming home to roost; the year of the bailout — 2008 — is heading into history as a momentous time of tumultuous market moves in stocks, commodities, currencies, and interest rates.

This year too witnessed the onset of a worldwide economic panic with an assault on the global economic system and our form of democracy. The forces of deflation and inflation continue to slug it out in a titanic struggle for dominance. We’ve managed to navigate the stormy seas with a steady hand on the tiller. One of the keys to our success has been keeping a sense of perspective.

As my premium research service, Options Hotline, is set to begin its twentieth year of advocating sensible speculation, I’d like to share some seemingly impracticable musings you may find useful.

In 2008, volatility skyrocketed beyond belief. Most market participants, even professionals, were caught by surprise. Big money was made and lost, both up and down, with astonishing speed. It’s long been known speculators make their fortunes from changing prices, and leverage is an important tool for speculators. Leverage involves using OPM (Other People’s Money) to try to make more money than you can with your own funds. Using OPM may augment your reward when you are right; but it may also greatly accelerate the risk of additional loss when you are wrong. That’s the aspect of leverage that so many forgot during the heady times of money trees growing to the sky.

Even some of the market’s smartest participants are done in by blind arrogance. The famous story of the 1990s rise and fall of hedge fund giant Long-Term Capital Management, excellently chronicled in Roger Lowenstein’s When Genius Failed, comes to mind. That cautionary tale is particularly apropos to today’s financial crisis. Successful trades blinded the firm’s brilliant partners to the possibility of failure, ultimately sealed their fateful demise, and threatened the stability of the entire financial system.

In this business, I believe you are better served by checking your ego at the door. Having a complete game plan includes preparing for the worst in every trade. Remember to always speculate based on what you can lose, not what you can gain. Applying sound money management principles (such as never adding to a losing trade) and utilizing the tools of Superleverage allow you to stay in the game and avoid being knocked out through inevitable times of losing trades.

Always anticipate the possibility of loss, and are prepared to withstand it, no matter the severity, because you positioned with always known and completely limited risk vehicles; never be surprised when the market moves against you.

Over the years, I’ve compiled an impressive record of forecasting the twists and turns of market price. The publisher is happy to provide you with every trade I’ve ever recommended, since taking the helm in October of 1999.

As a result, people invariably ask me what I think the market is going to do…

I always say that if I knew what the market was going to do, I wouldn’t have to work. The key to success in the markets comes from using technical levels of support and resistance to set your exit strategy for each trade. Make sure that you, or your broker, monitor your positions closely. The market doesn’t ring a bell when it’s time to get out. Have your plan in place ahead of time and you can smile, laugh, take your profit a step ahead of the crowd, and enjoy your accomplishment with a sense of wonder.

No matter your success, always be surprised when the market goes your way.

So, like me, never be surprised and always be surprised. Don’t forget that forecasters, even those with good reasoning and strong opinions, are practitioners of uncertainty. That view will serve you well.

I hope you found the abovementioned thoughts helpful and wish you all good fortune as you vie for fun and profit in the year ahead.

Sincerely,
Steven Sarnoff
Penny Sleuth

February 22, 2011

Musings of an Options Expert: 20 Years of Successful Trades was originally featured in the Penny Sleuth.