David Merkel at the Aleph Blog recently posted two interesting and very informative articles at his site:

Nine Points on the International Scene

Ten Points on the Funky Federal Reserve

Both articles briefly address major informative facts/thoughts on the state of International Markets and interesting facts about the US Federal Reserve.

Here are some selected points for consideration:

(regarding the International Scene):

1) In an open economy, you can control your exchange rate or your interest rates, but not both.  The first time I learned that was late 1986, when the Dollar crashed, then the bond market crashed (May 1987), then the stock market crashed (October 1987).

5) What makes a currency attractive?  GDP growth and high real (inflation-adjusted) interest rates.  The US has neither of those now.

(regarding the Funky Fed):

10)  [Consider]Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”  My way of saying it is that trying to control a system changes the system.  The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.

Read all the points on both articles for some weekend insight.

Chris Perruna recently provided some thoughts on how to take profits. Should you use a stop? Should it be a hard target? What if you have multiple positions in the profit zone?

“Many books attempt to explain how to take profits and several academics offer advice but most of it is fluff and biased to opinion.”

Chris then discusses a hypothetical account and risk parameters, and discusses three scenarios designed to help you understand a few potentially new concepts relating to protecting profits.

He concludes with the statement:

“Whatever the case may be, the idea is to capture profits while allowing them to grow within a reasonable risk/reward money management system that you have developed. [Once] you know what your objectives are, [then] design a system that will allow you to achieve them!”

Traders frequently discuss the “Risk to Reward” ratio when entering a trade, and often cite that it must be “Three parts reward to one part risk” or the trade will be deemed unacceptable from a risk standpoint.  But is this always the case?

It seems logical that the higher the reward/risk ratio, the better the trade, doesn’t it?  A trade with reward/risk ratio of 25 to 1 is far superior to one with a ratio of 3 to 1, isn’t it?  Who wouldn’t take the 25 to 1 trade?

Let’s look at it from the standpoint of normal volatility.

Just from a normal volatility standpoint (average daily price range movements, often designated by the Average True Range Indicator), the odds are far overwhelming that the market (price) will take out the one part risk before it grants you twenty-five parts rewards.

Stated differently, a stock is far more likely to move against you by one dollar than it is to move for you twenty-five dollars.

What might this do to an average trader’s overall picture?  A trader may have entered a “would-be” profitable trade, but he would never know because either the reward target was too large or the risk stop was too close.  Perhaps it is a combination of too distant target combined with too near stop.

Even reward/risk ratios of 5 to 1 can cause significant failures as a short-term trading strategy, because a stock – through normal volatility – is much more likely to move to take out the one part risk before granting the five part reward.

If the risk is $2 and target is $10, then normal volatility would state that the $2 stop would be taken out far before the complete $10 move has completed.

Sometimes, it is actually better to place the stop not just ‘beyond the noise,’ but far enough beyond the noise to be assured that any move that takes away your position was a valid one.

On the other hand, it may be more prudent to lower your profit targets to more reasonable levels, unless you deem yourself to be a position trader, in which case distant targets are acceptable.

But for most short-term traders, it would be better from a risk management and normal price volatility standpoint to set smaller targets and slightly wider than usual stops.

Of course, all this is predicated on the assumption that you have a trading system that grants you a greater than 50% win ratio.

When the odds of being correct are in your favor, it makes more sense to give yourself more room to be wrong (to avoid the “stop-gunning” or obvious pools of stops), and aim for a smaller profit target than to play for a large target and utilize extremely close stops.

Wednesday has arrived and departed, and now it’s time for the Mid-Week Overview of the Major US Indexes!

I always start with the Dow:

• Price broke to record highs (haven’t you heard it enough in the media?)
• Price is seeming to complete a downswing (or counterswing)
• Price is above a significant trendline area
• Price is above all major moving averages, which are displaying a bullish bias
• Momentum made a new high on September 17^th which forecast the new price high
• Momentum is now diverging relative to the price ’swings’ which signals a potential loss of buying pressure
• Volume has been declining on the recent swing up in price (bearish)
• Price should find support at the 13,700 range should it retest this zone (odds seem to favor it)
• Price is in a confirmed uptrend

Next is the S&P 500:

• The biggest technical signal is that we have “Non-Confirmation” with the Dow Jones
• The Dow is making new (lifetime) highs while the S&P is not
• Price is above a trendline, but whether it holds will be determined soon if not tomorrow
• The moving averages all signal bullishness
• The New Momentum High of about September 18^th forecast the new price highs as well
• Momentum is now diverging, as is volume (identical to the Dow Jones)
• Price is also in a confirmed uptrend

Realize that the Dow Jones is comprised only of 30 “Blue-Chip” companies that is supposed to represent all (most) of the US Economy, with some exceptions (utilities, etc).

The S&P is a much broader index that represents 500 companies. What this “non-confirmation” indicates is that money is just slightly supporting the larger capitalized, more established companies currently.

Look for price to attempt a test of the indexes rising 20 period moving averages at a minimum before resuming a strong upwards bias.

If price fails to retrace even to the 20 period EMA, odds favor a very strong upwards move in price as a result of that strength on the part of the buyers (and “short-coverers”).

Some say that “going short” is more dangerous than being long – I’m open to debate the question, but I do like to point out charts of interest that show interesting situations that warrant further attention.

Such is the case in Pulte Homes. We hear on the news just how horrible, unprecedented, catastrophic the housing market is and how it will never recover (I’m exaggerating). It’s enough to make you want to call up your broker and have him short thousands of shares of falling home builder stocks, isn’t it?

Not so fast, noble traders. It’s not that it’s a “Fade the News” situation, but more of a “the pubic is [almost] always wrong” situation. It seems easy:

Watch a news story, think about it, act on it logically.

Unfortunately, the market rarely rewards those who approach it with such little understanding or patience – at least not in the short-term. Yes, if you had been short any major housing stock, or even the housing ETF, you would have made double digit profits. But don’t you still need to look at the chart and plan your entries alongside carefully placed stops?

Of course you do.

What happens when you watch a story on TV and then try to act reactively to it?

In this example, we have news that unsold home inventory has fallen to a new low. Why not short a random homebuilder… Pulte Homes?

Here are headlines from Yahoo! Finance on October 2^nd:

“Wall Street Down on Home Sales Figures”

Main Idea Quote: “In economic news the National Association of Realtors said its pending home sales index in August fell 6.5 per cent to 85.5, a record low. The index has fallen 21.5 per cent in the last 12 months and has lost 16.5 per cent in the past two months.”

“U.S. Home Sales Send Major Indexes Into The Red” (Forbes Magazine Online)

“Let’s see just how far Pulte Homes fell today. I bet it fell 5% or more….”

Wait – why did the stock go UP today?!

It’s understandable to be confused when “things like this” happen, but realize it’s just part of the “market game” we all play.

Short Squeezes trap those who are short, and usually people (weak hands especially) who are short are a lot more reactive in terms of covering a position at the slightest hint of danger (in the form of rising prices). This is because short selling is by nature done on margin, and losses are (theoretically, though 99.9% unlikely) unlimited.

A short squeeze is like a cascade effect where price begins to rise, causing some shorts to cover, which usually attracts early buyers (trying to catch the absolute bottom), which causes more shorts to cover, which then causes a rapidly escalating situation of traders scrambling to buy stock to cover their positions. We know it is a short squeeze when price falls back down just as fast as it rose (or faster).

Anyway, what differentiates a “short squeeze” from a normal reaction is the rapidity with which it occurs, (usually) the volume spike, and the immense (relative) price bar range in relation to previous bars.

By the way, I would advise not to get tempted to rush into to buy Pulte Homes yet… if you’re desperate to own it, at least wait until it forms a proper bottom (with at least a retest of previous lows) and/or breaks solidly and convincingly above the 50 period moving average (which appears to have acted as key resistance lately).

As always, it comes down to looking at the overall structure, digging a bit deeper than “Uh, price should go down,” and keeping protective stops in case you get suckered by seeming price ‘games’ played by the professionals.

Be careful and try to have fun!

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