SKF – UltraShort Financials: A Lesson in Defense and Stops

Jul 17, 2008: 7:49 PM CST

I sincerely hope you weren’t majorly short the Financial sector the last few days – if so, I hope your stops took you out before carnal and potentially devastating damage was done to your account.  Let’s look at what went wrong (and right) so quickly.

Let’s assume you heard the news of how Financial stocks were collapsing, Indy Mac was taken over, the US Banking system was on the verge of collapse or any other manner of bearish news.  Let’s assume you’d heard that you can ‘short’ the financial sector (make money while they go down) in an ‘inverse’ fund (meaning, you ‘buy’ the fund to get short).  Let’s assume that you were told you can make a lot more money with an inverse leverage fund, such as the SKF.  Let’s assume you got short early this week.  May we also assume you didn’t know much about ETF funds and this was one of your first experiences with them?

SKF: UltraShort Financials ProShares:

So early in the week, your position was way up.  Something ‘bad’ happened on Wednesday.  Shares you had purchased in the $200 per share area suddenly plunged to $160 – weren’t the financial stocks supposed to plunge?  How could they possibly be rallying (and your position falling) if there’s so much bad news out there?  For heaven’s sake Jim Cramer – Mr. Bullish man – even told you to “sell everything, especially Financials” last week.

How could something so ‘sure-fire’ go so wrong so quickly?

From a high of $210 a share on Tuesday to a gap-down today and low of $136 on Thursday, the UltraShort (two times the leverage of the XLF) Financials ETF has absolutely killed the many people and funds that aggressively accumulated it, thinking it was a safe bet with all the rampant horrific financial news out there.

We generally learn that when extremes permeate the marketplace, short-term capitulation or euphoria takes over, and literally everyone who wants to buy has already bought (or sell) and there then exists a vacuum to the opposing direction, which is then exacerbated by profit takers and stop-loss levels being triggered.

If you failed to put in a stop-loss – even a ‘damage control’ stop beneath the rising 20 period moving average – you were in for a massive and tremendously unexpected surprise.  Even if you weren’t involved in this calamity, there are many lessons to learn.

1.  Never buy something that’s grossly overextended beyond its 10 or 20 period moving average

2.  Never buy (or sell) something when it seems it is a ‘sure-fire bet’ that can’t go wrong – often, trader confidence is negatively correlated with ensuing price action (if we’re “sure” prices will go up, then they’ll often go down – hard).

3.  Always trade with a stop loss, even if it is considered by you to be a ‘disaster’ loss.

4.  Try not to follow the crowd in our out of a stock or sector

5.  If you’ve learned these lessons, it may be safe to trade against (fade) such uniformity of thought

Also, only use leverage if you know what you’re doing, how the leverage affects you on the upside and downside, and know the worst case scenario provided it occurs – you may need to place tighter stops with a leveraged position.  Also, it’s best to use leverage only with proven experience and time in the market.

Also, don’t give up – the lessons we learn today, even if painful, will only make us better traders, if only we learn what NOT to do.

3 Comments

3 Responses to “SKF – UltraShort Financials: A Lesson in Defense and Stops”

  1. Anonymous Says:

    Thanks for another great post. I’m new to technical trading, this describes me very well, “May we also assume you didn’t know much about ETF funds…”. Do you have any recommended reading that will bring me up to speed with ETF’s?

  2. Panamon Says:

    COREY WROTE:

    Panamon,
    I wouldn’t say that – during a strong trend, in which one side of the market absolutely dominates the other, there are no ’swings’ in price. If there are no swings, then there are no oscillations in the indicator because the 3 and 10 period moving averages remain constant and equi-distant.
    During a strong trend move, it’s best to ‘throw out’ virtually all indicators except moving averages (for trade entries). During consolidation periods, it’s time to throw out moving averages in favor of oscillators. Nothing seems to work in all market environments.

    Great question!
    _______________________________________

    I appreciate this answer of yours to one of my previous comments: this is exactly the kind of indications learners like me need while studying charts.

    Anyway, I’ve just read it after seeing the SFK chart over here. This chart and its sudden crash seems to contradict your idea that “during a strong trend, in which one side of the market absolutely dominates the other, there are no ’swings’ in price”.

    Since I am not an expert, what I am asking is: despite ther bad news around for SKF, the trend seemed to be very strong and well defined. Isn’t this a sudden swing? Or was it so dangerous exactly because of its quickness?

    Thanks again for your suggestions about use of indicators and MAs! Keep it up!

    Panamon Rn+

  3. Corey Rosenbloom Says:

    Anon,

    We all have to start somewhere in learning about ETFs and how they can be a wonderful addition to a long-term portfolio, or add power and diversification to a swing-trading portfolio.

    There’s a lot of references out there to ETFs and there’s not a lot of misleading information – these are funds that trade like indexes and have a low expense ratio. Where you get into trouble is with these “leveraged” or sometimes even “inverse” funds. Please avoid leveraged funds until you have proven success in your account with ‘regular’ ETFs.

    I don’t know of any particular books to recommend on ETFs – start with Wikipedia and then move from there. There are even blogs entirely dedicated to ETFs.

    If I can be of further help, please let me know.