Both combine strategy, tactics, math, psychology, creativity, pattern recognition – the list goes on.

So without further ado, here is part III of the RENO series…

The world class poker player is both skilled detective and gifted story teller.

The detective aspect relates to keen observational skills: Paying attention to everything that goes on before, after, and during a hand. Using “clues” to make smart decisions with imperfect information.

The story aspect relates to bluffing and betting – shaping the actions of one’s opponent for maximum profit. Whether the goal is getting more chips in the pot (when the other guy is behind) or convincing a better hand to fold, one has to know the plotline to properly guide it along.

All of this goes back to narrative – the “N” in RENO. (See part one for explanation of the acronym.)

Action at the poker table is not static. It’s more like a soap opera, with lots of subplots going on:

• The guy you pegged as tight and conservative an hour ago just got sucked out on for a large pot. Now he is steaming and reckless, determined to take revenge on the world.

• The friendly lady you dubbed as shy and meek reveals a habit of defending top pair to the death.

• You just had a surprise run of cards and played an unusually high number of pots; now the entire table sees you as a loose bully, though you have only been betting for value.

Information is power (if you know how to use it). There is vital information embedded in the narrative .

The narrative is the story of what’s happening… the bits and pieces of information that come together in a profitable mosaic. The more information you have, the better you can tailor your responses (and your playing style) to the situation at hand for maximum profit.

Playing Above the Rail

Poker players have an expression, “playing above the rail.” This means playing the man (or woman)… focusing on your opponent, rather than the cards in your hand.

It’s more about what your opponent thinks you have, than what you actually do have. Sometimes the cards don’t matter. For those with knowledge and awareness, high quality opportunities come along that others don’t see.

But to exploit these opportunities – to play above the rail – you have to know the narrative.

Take the art of bluffing, for example. Some poker players, particularly those who understand the finer points of the game, are susceptible to a well-crafted, well-timed bluff. But other players simply cannot be bluffed at all!

As Johnny Chan once said, “You can’t bluff a sucker.” These unbluffables may be utterly blind to the dangers of the flop, the story you are telling with your bet, and the risks to their own chip stack.

(The way to beat an unbluffable opponent, by the way, is by either 1) making very large bets with your strong holdings or 2) letting them bet into you if they are aggressive. They won’t recognize the risk of these actions, and will pay you off when you have the best hand.)

Clearly then, certain types of player are excellent candidates for bluffing in the right spots – while others are terrible candidates.

Does it make sense to play these polar opposites the same way? Of course not. For one opponent, nuance and subtlety pay off. For another, it’s all about caveman poker (waiting for a strong hand, then bludgeoning him with the nuts). You have to know which is which.

So a fundamental piece of the narrative is having a strong sense of player profile — who is bluffable and who is not.

This comes through temperament and style assessments: Factors like who is loose (biased to call) and who is tight (biased to fold)… who is straightforward and who is deceptive… and so on.

Bottom line: If you are playing above the rail, you are factoring in the type of opponent you are up against.

The trading equivalent is factoring in market conditions. Is the market environment “hot and excitable?” Or is it “cold and stagnant?”

At the time of this writing, we are in the later stages of a grind ‘em up bull run, in which the market drip, drip, drips a little higher each day while the permabears tear their hair out. This particular set of market conditions warrants a particular response. When conditions change, our Live Feed game plan will change too…

The macro narrative and the micro narrative

In poker, the macro narrative relates to all that is going on at the table:

Styles and temperaments (loose vs. tight, aggressive vs. passive)… stack sizes… who is “hot” and who is “cold”… key hands and inflection points that may have changed the tone of play…

The micro narrative, in contrast, is what happens with each individual hand.

Novice players tend to be overly focused on the micro narrative, i.e., their own cards and what they made on the flop. This is the type of player who will go down in flames with Aces or Kings, not seeing or registering that a big pair is still just a pair.

In markets, the micro narrative relates to individual trades or investments. The ultimate “micro narrative overfocus” example is the employee with 90% of their retirement funds in company stock, or the hedge fund manager completely married to one position. (Hello, Phil Falcone!)

There is a broader world out there, and it can be dangerous to ignore.

Great traders know to focus on the macro narrative and the micro narrative simultaneously. They want all the elements to line up before putting chips at risk.

(This idea was expressed another way in our global macro series, in a description of The Market Tower. When the macro and micro narratives line up, the top and bottom of the tower link together.)

Style Guidance

If you’re really in tune with what’s happening around you, the narrative will guide your style of play.

For example, in a recent multi-day WSOP tournament, I wound up in conversation with a pro at the end of day one (after the chips had been bagged up for day two).

“You’re a very tight player,” the pro said. “You should use that image to your advantage.”

He thought I was tight after sitting at my table for seven hours. What he didn’t realize is that, in the long run, I have no set style and no set image. It is all situational… all depending on the narrative.

On that particular day, there were two extremely bold and aggressive players to my left, and both were deep stacked – so I went into “tight” mode for hours on end.

On day two the situation changed: Finding myself chip leader at a new table populated with medium stacks, most of them nervous about making the money bubble, I ramped up the aggression.

From the perspective of day one my play was tight and conservative to the extreme… from the perspective of day 2 it was loose and aggressive to the extreme. But really there were no “extremes” – just proper responses to the environment.

It’s exactly the same in markets. For instance:

Anyone who assessed our trading style based on the year 2011 would call us conservative. We were active but kept the risk dialed down — taking very small positions as a general rule — because of the flighty and dangerous conditions. (2011 was exceptionally choppy and squirrelly. Can I get an amen?)

But under different market conditions, the same Mercenary trading profile dubbed “tight and conservative” (by 2011 standards) could be stomping around like Godzilla: Taking large chunks of accumulated profits (while still respecting risk) to ramp returns from +25% to +40%, and so on.

Flexible response as the narrative changes!

JS (jack@mercenarytrader.com)

Basically two guys from Yale discovered that, while “the hot hand” in basketball and other sports is a myth, in bowling it’s the real deal.

In basketball, for example, a shooter’s “hot streak” really just represents fluctuations around the long-term statistical average.

In basketball, the better your field goal percentage overall, the more likely you are to sink X shots in a row simply as a matter of chance.

For NBA players, “hotness” does not have a documented mathematical tendency to persist. A string of threes early in the game, does not increase the likelihood of sinking them later in the game.

In bowling, though, strikes DO tend to beget more strikes — and the numbers bear this out. Yale number crunchers Gur Yaari and Gil David confirmed this with a massive sample size: More than 40,000 bowling events between 2002 and 2011.

Bowling champ Walter Ray Williams has a theory as to why the streaks persist:

Williams, who is nicknamed “Deadeye” for his peerless accuracy, says it’s all about getting a read on the lane. Every lane reacts differently due to varying amounts of oil that determines how much each shot will skid and hook. Find that line to the pocket early, he says, and you can pile up strikes all game.

- The Secret to Success in Bowling: Getting Hot

One could argue, then, that the connecting factor in bowling and trading is the presence of exploitable conditions.

When you find “that line to the pocket,” as Williams puts it, you can get into a (literal) groove that increases the odds of hitting strike after strike.

The WSJ article title is wrong, of course. The secret to bowling success is not “getting hot,” but rather finding the line to the pocket, i.e. figuring out the strategy that works in the first place.

The trading connection is that, analogous to oil patterns in a bowling lane, certain market environments favor certain types of trading methodologies and approaches.

Sometimes trend conditions persist. At other times, reversion to the mean conditions persist. While market conditions change, like the seasons, a current set of conditions can stick around for an extended period of time.

For discretionary traders, a winning streak can also relate to being in synch with ‘the market script’. If you are reading the signs correctly, odds increase that the narrative will continue to unfold as you anticipate.

If a strategy or trading methodology is ‘hot,’ in other words, there is a greater than random chance that wins could persist, for the same reason that streaks in bowling persist.

(In an idle side note relating to this, I’ve often wondered to what degree the first generation of commodity futures traders benefited from a powerful inflation bias that lasted for years and years… just as daytraders made killings for an extended window of time in the dotcom boom… cash rich private equity guys killed it in the liquidity boom years of 2004-2007… and so on.)

Bottom line: With trading, as with bowling, sometimes you’ve got the lane pegged, and sometimes you don’t. When you don’t, conserve your capital and lay low… but when you do, exploit it!

This is not an argument for getting cocky or sloppy after a string of good trades, but rather a simple explanatory train of thought as to the mechanics of that old trading wisdom: “When trading poorly, lower your exposure; increase exposure when trading well” (Paul Tudor Jones paraphrase).

There are many ways to do this, as we explore in the MT Driver’s Manual (a series of articles that will resume shortly!). If you can forgive the metaphor switch, it’s critical to recognize when conditions are optimal… when to press hard on the accelerator… and when to use the brakes.

(Final disclaimer: None of us can be good at everything — I can’t bowl worth a crap.)

JS (jack@mercenarytrader.com)

Founders’ note: And two became three… we are excited to announce a new addition to the core Mercenary team.

You’ve already seen valuable contributions from Nathan O — an excellent trader Jack first met ten years ago — and now we are taking things to the next level. It’s going to be a great year!

Jack & Mike

~~~

Nathan O here: I am excited to tell you that I’m officially joining Mercenary Trader.

No doubt this creation is Jack and Mike’s baby, but I am very excited to become part of the family. Hopefully I’ve already added some value for you through my contributions these past few months.

I have to admit I take any affiliation or partnership very seriously, and much thought went into this decision on both sides.

Though they didn’t ask me to explain “why” to the Mercenary community, I thought it was important to give the reasons I think this will be a great fit – and an added benefit to you (the Mercenary audience).

We are equally passionate about trading. It is hard (impossible?) to fake passion. If someone truly loves something and is committed to their craft, it comes through without effort.

I was recently able to spend the better part of a week with the guys – a visit to Mercenary HQ – and  see them in action. More importantly we spent hours talking about what we love – trading!

We approach markets from the same risk perspective. Though our styles and methods are not identical – my approach is very mechanical in nature – one area, and probably the most important, where we are like twins separated at birth is risk management. The mutual goal is outsized returns, WITHOUT outsized risks.

We share the same frame of mind when trading. While I was busy trying to make pencils stick into their office ceiling (due to my mechanical approach), Jack and Mike were setting up trades, executing them and doing research for the next day’s setups. While that in and of itself is not earth shattering, the calmness and decisiveness they displayed while doing it sold me on becoming part of the team. Excessive emotions or uneasiness during trading hours are warning signs to me, and unacceptable when it comes to managing money.

These guys are the real deal (though I can’t say I expected anything less)…

We are all sincere in our desire to help traders. There is a lot of quantity out there, but not much quality. Professional, semi-professional and beginning traders all have similar issues with finding sources of credible, useful information they can trust, provided by real traders who eat their own cooking!

I see real commitment here, both to helping traders in all kinds of ways – from learning the basics of risk management to raising capital for a hedge fund —  and I find the Mercenary vision refreshing: A place built by traders, for traders, that will keep adding depth and value as the community expands.

It simply fits. Kind of like finding that special breed of dog (Doberman of course), that golf club that swings just right, or the sports car that handles like a dream, sometimes things just click.  It doesn’t happen often, but when it does, you know you can’t pass it up.

I am excited about what the future holds as we kick things into high gear. There are new developments ahead for 2012 – some of them big – so stay tuned!

In the meantime, we would love to hear from you: How has your Mercenary Trader experience been so far? What do you like best about the site? What would you like to see more of? Less of?

Kudos and criticism, questions and comments welcomed via feedback@mercenarytrader.com.

You can email me directly now too: Nathan@mercenarytrader.com.

To Your Trading Success,

N

From Felix Zulauf’s Market Prognosis, one of the smartest things we read last week:

Legendary Swiss investor Felix Zulauf believes that the current rally in risk assets is likely to last until at least the end of March, but that global sharemarkets will again succumb to downward pressure in the second half of the year.

In a wide-ranging interview with Business Spectator, Zulauf, who is president of Zulauf Asset Management and who has been a member of Barron’s Roundtable for more than 20 years, paints a gloomy picture of debt-laden industrialised countries, where central banks have no choice but to print money in an attempt to stave off dire deflationary pressures.

He also predicts that dwindling demand from the West will force China to redouble its efforts to boost domestic consumption, but that this will reduce China’s rate of economic growth.

The whole piece is worth reading… Zulauf’s well articulated world view largely meshes with ours.

Meanwhile the S&P has shown “relentless strength” according to Bespoke Investment Group, with 1% decline days nowhere to be seen… the Dow just kissed 13,000, its highest level since May 2008… and the Nasdaq tagged the backboard with its highest close since, drum roll, December of the year 2000!

Where is all this bullishness coming from?

It’s a “no news is good news” phenomenon, applying in particular to bad juju from Europe and China. In other words, as long we get  “no news” of meltdown, default, civil unrest gone wild etc, sovereign and systemic risks are pushed aside.

Why? Because money managers have some catching up to do. As Reuters clarified on Monday, hedgies are ramping up the risk:

Hedge funds are cranking up their bets in equities and credit in 2012′s buoyant markets in the belief that the euro zone, U.S. and Chinese economies will fare better than many were fearing last year.

Many funds think the European Central Bank’s long-term refinancing operations (LTRO), which flooded markets with 489 billion euros ($644 billion) of cheap cash in December and provide more this month, are a turning point in propping up the region’s battered banks.

They are also betting that China, which is facing a fifth successive quarter of slowing economic growth, will experience a so-called ‘soft landing’, while the U.S., which saw its fastest growth in one-and-a-half years in the fourth quarter, is firmly on the recovery path.

The average hedge fund rose 2.6 percent in January but this was behind the S&P’s 4.5 percent gain, according to Hedge Fund Research, and some funds missed out on the rally after taking a cautious stance towards the end of a turbulent 2011.

Many managers are now hiking borrowing to make their favorite bets punchier, or shifting the balance between their long and shorts to help them profit from market gains.

“What we’re hearing from a number of managers is that the appetite for risk has risen,” said Frank Frecentese, global head of hedge fund investments at Citi Private Bank.

“Their view on Europe is that the possibility of an extreme left-tail event has lessened, the U.S. is doing moderately better than expected and the risk of China … heading for a hard landing has lessened.”

But what about Greece? Fuhgedaboudit… as long as the European talking heads can continue to “kick the can down the road,” the deflationary pain of the periphery countries is someone else’s problem.

As many others have observed, the bailouts are not meant to help Greece, but the banks in harms way should the system go down. As long as it functions, let liquidity and U.S. optimism rein.

One big danger for bulls is high and rising crude oil. Independent oil trader Vitol thinks $150 could be back in the cards. Via the Financial Times:

The world’s largest independent oil trader says oil prices could jump this year to a record high above $150 a barrel because of growing tensions with Iran.

Ian Taylor, chief executive of Vitol, said on Tuesday that the commodities trading house’s main scenario was for crude oil prices to remain at around current levels of $120 a barrel for the balance of 2012. But he warned: “Geopolitical risk, especially in the Middle East, creates potential material risk to the upside.”

Mr Taylor said oil prices could even surpass the record high of nearly $150 a barrel set in mid-2008. “It is unlikely, but it is possible,” he said when asked whether prices would rise to a new record.

Airline investors certainly didn’t appreciate the ominous outlook for crude.

US Airways Group (LCC, chart above) was representative of Tuesday’s action in the group, with ALK, DAL, JBLU, LUV etc all showing similar range expansions to the downside.

Oil has risen to its highest levels in 9 months. A geopolitical flare-up — likely tied to Iran at this point — could lead to a huge spike overnight. At the same time, we are wary of the heavy speculative position in oil.

As our friend Peter Brandt pointed out in his excellent chart review of the energy complex this week:

There is a MAJOR problem with the bull scenario in WTI Crude Oil — the open interest story. There is currently a near record open interest of 1.29 million contracts.

The composition of this open interest represents a near all-time record short position by commercials and long position by the large speculator (including the funds).

Typically it does not pay to bet against the commercial interest in the futures market, especially when the commercial interest is so heavily slanted in one direction — but there are rare exceptions. So, while further gains in price are possible — even to the extent of the targets identified in this document — one must question where the additional buying will come from given the extended commitment of the speculator at present. A close below last week’s low in Crude Oil could lead to cascading stops.

The problem with geopolitical events is the low probability of an actual conflict. It’s the poker equivalent of drawing to a straight flush: If it happens, Oh, Mama! But odds are the more boring result will prevail…

We are more constructive regarding the outlook for metals, particularly base and industrial metals.

Copper, for example, kicked off the week with a big boost, likely on China’s easing news, to key off $3.70 support. From China daily:

China’s central bank on Saturday announced to lower banks’ reserve requirement ratio (RRR), underling its efforts to ease short-term credit crunch and secure growth in the wake of a lacklustre external market.

The cut, the second of its kind in three months, will drop the RRR by 50 basis points to 20.5 percent for large commercial banks and 17 percent for mid- and small-sized banks, the People’s Bank of China (PBOC) said in a statement on its website.

The move will become effective on February 24 and release an estimated 400 billion yuan (63.54 billion US dollars) in capital into the market.

Copper is potentially playing off support in the $3.70 per pound area.

If optimism on Europe and China holds — more can kicking, more rate cutting, more money printing blah blah blah — then there is reason to believe bullish fund managers can continue to press their bets against an optimistic backdrop.

The threat of an oil spike will weigh, as will the threat of Europe’s duct tape finally splitting at the seams… but how tired are those tunes?

So tired, and so well ignored, that the professional bears are spilling tears in their beer and throwing up their hands — as Bob Janjuah of Nomura illustrates (via ZeroHedge):

I am not well equipped to navigate bubbles where tactical views and secular views are all thrown into the melting pot together, where there is no visibility, where – as one client put it to me recently – we have Monetary Anarchy running riot, where the elastic band between the ‘real’ economy and the current liquidity-fuelled markets is stretched further and further beyond credulity, and where history tells us that policymakers will happily stand by whilst bubbles are being pumped up, and hope that they are onto their next job before it all comes tumbling down.

My personal recommendation is to sit in Gold and non-financial high quality corporate credit and blue-chip big cap non-financial global equities. Bond and Currency markets are now so rigged by policy makers that I have no meaningful insights to offer, other than my bubble fears.

We feel ya Bob. That’s why we aren’t trying to guess when the manipulation circus will end.

Just picking our spots, taking our shots and riding trends…

In the Mercenary Live Feed we are currently positioned for “more of the same,” with a strong bias toward industrial and metal miners, bullish exposure capping bearish by more than 2 to 1.

Finally, the most intriguing read of last week was also a sad one, as another trading legend inches towards the door.

In “A secretive hedge fund legend prepares to surface,” Fortune peeks under the kimono of Louis Moore Bacon, the founder of $15 billion AUM Moore Capital Management.

In the piece we learn that Bacon has had to endure his second down year in the past four (minus 2.2% in 2011)… that his “heir apparent” left to start his own fund… and that rather than succumbing to the financial equivalent of a rectal probe from the Securities and Exchange Commission, Bacon is seriously considering the “family office” route already taken by Stan Druckenmiller and George Soros.

(By the way, check out our Exit Soros Retrospective if you didn’t catch it the first time around.)

The Fortune piece is filled with interesting tidbits like this:

Bacon has created a culture at Moore of long hours and exacting standards. Of the numerous portfolio managers Moore has employed over the years, only about a dozen have been given $1 billion or more to manage, with the lion’s share being handled by Bacon himself. And traders, who earn a base salary of $250,000 a year at most, live in fear of having their capital and resultant bonuses scaled back if they make a bad trade and aren’t given time to earn back losses.

“Louis wants to make sure that if you have a bad stretch, he can get rid of you,” says one fixed-income trader who walked away from a potential job at Moore because of those concerns. “Louis feels like he’s the manager of the Yankees. He can have a different team every year and they can still win the World Series.”

The global macro titans are retiring, Fortune asserts, because the mega-profitable, home-run style “macro bets” are getting harder to find.

That’s good news to us, though — the next generation — because markets move in grand cycles, and the current drought will be a monsoon quickly enough. (Long bonds and the yen are already looking good…)

JS (jack@mercenarytrader.com)

That being said, we also appreciate the steady income streams that can be generated from a short-term trading system.

As with the roster of a championship baseball team, we believe the ideal trading lineup contains a mix of strategies. Along with your sluggers and homerun hitters, you also want your steady performers – reliable at bats (i.e. trades) that serve up singles and doubles on a consistent basis.

While trend trading and swing trading both have their strengths and weaknesses, together they complement each other very well.

In trading terms, shorter term trading systems – which often exploit “reversion to the mean” tendencies – can provide returns during choppy market environments, while trend following is naturally more suited to strong directional bull and bear moves.

Trading a mix of longer term and shorter term systems can thus be beneficial to your equity curve. Drawdowns are reduced during choppy periods that a long-term system brings… and yet you don’t miss out on the monster trend moves that a swing system can’t catch.

Many traders seem to think it has to be an either / or scenario. They proudly tell their friends and colleagues that “I am a DAY TRADER”… I am a “SWING TRADER”… I am a “TREND TRADER” and so on.

This doesn’t make much sense to us. A trading style is not an exclusive member’s only club!

Here are some further advantages of short-term (swing) systems:

• Capital at Risk for Shorter Periods of Time. For most short-term swing trading systems (including the ones I’ve developed), you may only be in a trade for an average of 5 to 7 trading days – sometimes even less!

Having capital at risk for shorter periods of time is no bad thing. If you are wrong on a swing trade, you will know it quickly, freeing up your capital for fresh opportunities. In addition to that, your capital is constantly being redeployed in new, high quality opportunities (assuming your system has a good means of finding them).

Many swing trading systems employ “time stops” in addition to price-based risk points. Since this type of trading is momentum based by nature, the lack of it tells you it is time to move!

• Lower Capital Requirements to Trade. Let’s face it: Not everyone has the account size to trade certain strategies.  A futures market trend following strategy (even using mini-contracts) requires a sizable chunk of capital. Various options strategies require the equivalent of hundred-share-blocks (the minimum size of one option contract) to put positions on.

With an equity-based swing system, however, the “granularity” is high in terms of trading individual liquid stocks. The approach is friendly to a smaller capital base (while still workable with a very large one).

• Diversification of Methodologies. Correlation risk – when everything goes bad at the same time – is a problem for many traders. Similar to the benefit of trading non-correlated markets, having a roster of non-correlated strategies adds diversification to the portfolio.

Accessing both long and short-term strategies can provide for a smoother equity curve versus trading one strategy alone. (Add income-generating options strategies to the mix, and you have a true multi-dimensional recipe for success.)

• Advantages of Defined Profit Targets. When it comes to the risk/reward profile on trend trades, we tightly define the “risk” but leave the reward side open. We don’t want to know our return – and we surely don’t want it capped. Trend trading is about building superior returns with a handful of very large trades over time – knocking the cover off the ball.

With shorter term swing trading, however, we use defined profit targets along with defined risk – making it very easy to determine the expected Risk/Return profile of a trade. Defined targets add clarity and consistency, making it easy to know exactly where you plan to exit… the max length of time you will spend in the trade… what your return relative to planned risk will be… and so on.

• Set-and-Forget Capability. Using “bracket orders,” where entry orders, stop losses, and profit-taking limit orders are placed simultaneously, you can identify and set up trades in the morning before market open, or after market close the night before.

In other words, even with a short-term system, you don’t have to be glued to a trading screen or risk making emotional (i.e. bad!) decisions in the heat of the moment. This allows you to trade your short-term system effectively while still having a life, rather than being glued to a screen all day.

• Psychological Benefits. A great trend trade, or a big “macro” trade, can often take weeks or even months to play out. Then, too, there can be weeks or months of waiting between one big trade and the next. Patience is an edge in markets, but all traders like to ring the cash register… which is why it can be nice to have a short-term system running alongside. It can help soothe the psyche, and make it easier to be patient, when you get to hear the “ka-ching”  of profits on a regular basis every few trading days.

In conclusion, we are “big game hunters” and trend followers by nature and by design – and always will be – because that is where the truly awesome profits are made.

But with that being said, we like buttery smooth equity curves and the sound of ringing cash registers as much as anyone. All methodologies have their strengths and weaknesses, and there is no such thing as a perfect trading approach… but your results might be nicely enhanced by a short-term trading system.

For the next article in this series, we’ll talk about things to look for (and things to avoid!) in a short-term trading system.

N

p.s. We’d love to hear your feedback on this topic: Nathan@mercenarytrader.com

“We are literally running out of superlatives to describe how much we hate bonds.”

- Jeremy Grantham, GMO Advisors

As of this writing, the 30-year treasury yield is a shade above 3%.

Who wants to lend to Uncle Sam for three decades at that rate? Apparently lots of folks.

The trouble with USTs, of course, is not the risk of getting your money back. It’s the risk of being paid in depreciated dollars.

In a recent preview of his annual letter, Warren Buffett declared bonds “among the most dangerous of assets,” adding that “right now bonds should come with a warning label.”

The full Buffett quote (emphasis mine):

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Buffett echoes the sentiment of Jim Grant, who likes to quip that, rather than offering risk-free return, U.S. treasuries now offer “return-free risk.”

Weirdly enough, the bearish story for long bonds is linked to the bullish recovery scenario for the global economy.

If the world continues to look terrible — caught between the Scylla and Charybdis of sovereign risk and deflationary forces — then USTs will continue to function as a grudging safe haven. There is just too much capital sloshing around out there, and too few shelters from the storm.

If a recovery mentality truly takes hold, however — and affirms itself in the data — then the desire to hold treasuries could evaporate. Accelerating economic growth, against a continued backdrop of expanding credit and loose monetary policy, could force investors to dump their low-yield UST holdings like last season’s reality show star.

Not to mention the abundance of increasingly attractive alternatives to Uncle Sam, even for nervous ninnies. A safety-seeker looking to park cash these days might be better off lending to Brazil, or Canada, or any number of blue chip multinationals… all of which have pricing power and growth participation (through agriculture, energy, global sales etcetera).

What could keep bonds strong and yields low? Basically, fear and deflation.

The treasury bull case is twofold: 1) Growth will continue to suck, 2) Europe will continue to terrify. Elaborate arguments for owning USTs boil down to historical evidence for deflationary bias in heavy-debt-overhang, post-credit-bust environments.

One thing is clear, though: At some point bonds are going to go tapioca, because rates can’t stay low forever. (Nor can a printing press run to infinity.) Our focus isn’t to predict the timing of the bust, but to make sure we’re there when it happens.

To that end, the long bond chart raises an eyebrow…

In a related “government folly” department, another enticing big short candidate for 2012 is the Japanese yen.

To put it simply, Japan is a demographic time bomb. The insanely leveraged Japanese financial system is internally funded. Japanese Government Bonds (JGBs) are such a lousy proposition that only Japanese savers (and Japanese institutions) still want to buy them — and many savers buy without knowing it via institutional proxy.

But at some point — an unknown tipping point — Japan’s savers will morph into spenders as Mrs. Watanabe hits her golden years. When this tipping point comes — or flight instinct kicks in via anticipation of its arrival — the retiree savings flows that prop up the JGB market slow down or even reverse. From there it is only a short period of time (a downward spiral really) before Japan loses the ability to service its massive interest payments.

When this eventually happens, as the law of gravity argues it must, you get a case of what the IMF calls “exploding debt dynamics” — a phrase Argentina is all too familiar with. For a country with sovereign control of its currency — something Greece wishes it had but does not — the only way around such a disaster is to print like mad, i.e. “Kick it Weimar Style”…. in which case the yen gets vaporized.

The storm begins with a small gust of wind. And what have we here, via Marketwatch:

In a surprise move on Tuesday, the Bank of Japan expanded its asset-purchase program and set a temporary inflation target of 1%, while keeping interest rates near zero.

…The additional easing came as a surprise to the market, with a Dow Jones Newswires survey of economists ahead of the announcement showing expectations for no new action from the bank.

The chart below shows FXY, the Japanese yen currency shares ETF. For expressing a trade, either Japanese yen futures or the forex vehicle USDJPY might be better… but FXY, being denominated in dollars, clearly displays the top. (Another way to express the trade is YCS, the ultrashort Japanese Yen ETF.)

Let it be said that bond bears and yen bears have been growling for a long, LONG time. The bearish Japan trade has even been called the “widow-maker” because so many traders have lost their shirts betting on a JGB implosion.

This is a natural function of how pessimistic macro predictions, and crisis situations in general, tend to work. Mr. Market has a well established habit of ignoring worrisome macro factors completely… until the day he starts paying attention, at which point all hell breaks loose.

Our 2012 strategy is two-fold: As a matter of preparation, we want to be Johnny On the Spot if and when a “big trend” macro opportunity breaks wide open. We won’t obsess over bonds, yen, etc… but if the train gets to rolling, we’ll be on board.

In the meantime, because the wait between “home run” style opportunities can sometimes be long, we’ll be focusing on bread and butter income generation with high probability swing trades — exploiting mean reversion tendencies and day-to-day market movements week in and week out.

Whether “risk on” or “risk off,” we foresee a great year ahead for traders… and a couple home run cuts (via bonds and yen) would only make it sweeter. (If you want to find out more, check out the Live Feed!)

JS

In these days of currency debasement, some would say “cash is trash.”

And yet, there’s nothing quite like a freshly minted brick of c-notes — $10,000 in crisp cash — nicely filling the groove in your palm.

Yours truly was reminded of that feeling with a recent 5-figure cash at a World Series of Poker regional tournament event.

We expect plenty more final tables to come…  and in light of that, it seems timely to roll out part II of the RENO series. (It’s been a year since the first one, but hey — sometimes we get sidetracked.)

Part I described the RENO acronym — Range, Equity, Narrative, Odds — and the general application to both poker and trading. In part two we’ll talk about “the four types of equity.”

Not equity as in common stock equity, but rather situational equity… the cumulative advantages, or disadvantages, that are present in a poker hand (or a trading scenario).

In part I we described it like this:

• Equity speaks to the advantages you bring to the hand. For example, if you have “position equity,” your ability to act last in the hand amounts to an informational edge. If you have “hand equity,” it means your holding is strong in the conventional sense (a strong starter hand). “What’s my equity,” i.e. your empirical justification for putting chips at risk, is an important question we’ll discuss further via the second acronym.

“Ship It”: exclamation made after winning a big pot, i.e. in poker.

- Urban Dictionary

We’ve already established RENO as the main acronym: Range, Equity, Narrative, Odds.

So here is the second acronym: SHIP.

Delving deeper into equity — with SHIP — we have Stack equity, Hand equity, Image equity, and Position equity.

• Stack Equity: How does your chip stack size up to your opponent’s? Smaller stacks are more vulnerable to volatile swings. Larger stacks have greater ability to both 1) absorb volatility and 2) dole out volatility as punishment. Small stacks get called more often, due to a lack of “firepower” behind; large stacks are respected, and challenged less often, because of the damage they can do on future streets. In poker tournaments especially, stack size considerations are dynamic and critical.

• Hand Equity: What is the strength of your hand — the actual cards you are holding? This is the most straightforward aspect of situational analysis. If you are dealt Aces or Kings, you can raise heavily (or push all in) from any position, and (in most cases) go up against any player at the table. A pair of sevens on the other hand, or a highly speculative hand such as 8-9 suited, would require much more consideration.

• Image Equity: How are you perceived at the table? If you have been playing an extremely conservative style, folding hand after hand for the past two hours, you may be perceived as “tight,” in which case your opponents are more likely to accept a credible bluff. Tight image equity allows you to make moves (pick spots) to take down large pots with nothing. Conversely, if you have been playing hand after hand and showing a wide range of holdings, you may be perceived as “loose”… in which case your ideal scenario is betting a very strong hand when opponents don’t believe you — thus getting paid off by sherriffs determined to “look you up”.

• Position Equity. As Tommy Angelo observes, “saying that position is important at poker is like saying that altitude is important at flying, or that water is important at swimming.” Position is the ability to act last (or close to last) in a hand, giving the advantage of information flow: He who acts last can first assess the actions of his opponent, whereas the player acting first does not know what his opponent will do.

The basic idea is that, the more equity you have, the more reason you have to play the hand. It isn’t necessary to be high in all four categories — for example, under the right circumstances it could make sense to play with a hand equity of zero (large stack, great position, fearsome image, great read on your opponent, allowing a raise with any two cards).

But if your cumulative equity is not high enough, or you otherwise get a red light, it makes sense to reduce risk and fold. Having a process for considering all these elements (including the as yet undiscussed Narrative and Odds) is invaluable in the heat of the moment.

So how does all this cross over to trading?

For one thing, poker and trading are similar in the need to simplify complex environments on the fly. As the book Decision Traps observes:

“Everyone, from the greatest genius to the most ordinary clerk, has to adopt mental frameworks that simplify and structure the information encountered in the world.”

In trading, stack equity could relate to your available risk capital and/or the available risk (volatility) in the market.

Having a large stack would be akin to having risk capital accumulated. A trader who is sitting on big profits for the year, for example, might have an easier time risking 3% on a speculative trade than a trader who is flat to down 10%.

The volatility of the market could also stand in for the volatility of one’s opponent. Trading in wild and woolly conditions is like playing at a loose aggressive table with the chips flying — you had better be comfortable with some wild action, and prepared for it beforehand.

Hand equity of course synchs up with the quality of the trade. Some trading ideas are so powerful and compelling, the general backdrop doesn’t matter at all: These are the trades with high hand equity, like holding AA or KK before the flop. Other trades are far less of a sure thing, and may demand a very specific set of market conditions to execute.

Image equity is the toughest to translate, because the market is a faceless opponent. But a trader can self-assess based on many of the factors poker players observe in their opponents: Is the trader acting strong? Is he acting weak? Is there a presence of calm and relaxed confidence… or high strung nerves and creeping fear? Traders can also benefit by playing against type when it comes to mass market psychology; be greedy when others are fearful (loose when opponents are tight), and fearful when others are greedy (tight when they are loose).

Position equity relates to the timing of a trade, or the decision making process of when to make a big investment. At the poker table, risking your chips “out of position” can get you in trouble. Similarly in markets, coming into a trade too early, or anticipating a turn that hasn’t happened yet, can feed the same problems. The poker player with position equity has the informational advantage of acting behind his opponents. The trader with position equity has similarly waited for the key tell to reveal itself — for Mr. Market to tip his hand — before putting meaningful capital at risk.

The SHIP acronym, along with RENO, is one I use in actual poker play. It takes no more than a few seconds to run through key factors before making an important decision at the table. (Narrative and odds factor in too, which we’ll talk more about later.)

Whether or not you feel inspired to use this rundown in your own trading (or poker playing), hopefully you can see the value in creating a routine process for situational analysis… a way to quickly and efficiently check off the key factors in a complex decision situation, whatever that may be.

JS

For me (Mike) it was a stint swing trading S&P E-mini’s in an under-capitalized account with a semi-mechanical program that I halfhazardly designed in my early 20′s.  For Jack, it was a precious metals trade that exploded to the upside, and then mockingly took all of the gains away.

You can read Nathan’s story below, keeping in mind that sometimes the hardest trading lessons end up creating a knowledge base that can lead to much greater profits over time.

Trade ‘em well!
MM

Get In, The Water’s Nice and Warm…

When talking with the guys from Mercenary last week we got on the subject of futures trading.   What struck me right away was how each one of us lit up (as much as is possible on the phone and through email) when the subject of commodities trading was brought up.

I can’t even really put my finger on it, but there was always something nostalgic about the futures market.   Granted, it is not like it doesn’t exist anymore, but the whole process of calling in orders to your broker (does anyone remember pre-online trading?) and watching for the end of day prices in commodities was pretty cool.

Even though I had no clue what I was doing at the time, the mere reaction of family and friends when they heard the word commodities trading was priceless.    Though maybe 1 out of 10 had a positive story or reaction, almost everyone else somehow knew someone that lost “a fortune” in a short amount of time.

That didn’t stop me, as I opened up my account after ordering a seasonal trading program from a well know commodities trader.   He talked about these repeating patterns and showed some impressive percentages for buying on X date and selling on Y for all the commodities.

It was like a bible of repeating trades that were destined to win.    You simply called in the order to buy at market open and sell at market close days later.   This was all done by simply following the manual with the dates.    What could be easier?

There was a certain swagger when you could tell people you traded futures.    The average bloke traded or invested in stocks and mutual funds, but the guys that wanted to take the bull by the horns had no interest in using that much capital on a single trade.  In addition, we would sell short as easily as going long without paying interest.

Plus that leverage baby…….that was the secret formula and how we would squeeze profits with only a small amount of capital.    Those big CTA’s and I now had something in common, though I am pretty sure they carried a much larger bankroll.    Even more shocking was the fact that they risked less per trade than I did as a percentage of capital………what lightweights!

Fast forward a few weeks later (after some nice profits) and I found out what “limit day” meant.  As embarrassing as it is to admit, at the time I didn’t know what a “limit day” was.

“What do you mean I can’t exit my position??”   I am sure under the broker’s laughs, he still appreciated my commissions.

Looking back at it many years later, I recall I was not even buying the liquid “front-end” months and the spread/slippage I paid upon entering and exiting was likely criminal.     Had the limit day been in my direction I suppose I would have felt differently about that new term.

Luckily I only suffered two days of that before I got out.    All my profits were gone and it sure seemed to happen fast.     Despite the profits and losses coming at a rate I had never experienced before when trading (especially when compared to “investing”), I still look back with admiration for those markets.

I have gone back various times (once even with a short stint at day trading the S&P) with my taxable accounts.    Commodity markets provide some of the best trends, and if you pyramid like the “turtles” you can earn some parabolic returns.

If I had not traded futures I would have probably never run across the “turtles”, mechanical trading or proper risk management.    Luckily with the advent of ETF’s, you can do a pretty good job mimicking a CTA portfolio.     There are leverage advantages with trading futures directly that you don’t get with ETF’s, but had I not traded commodities I don’t know that I would have incorporated them into my own ETF portfolio.    When trading retirement assets it is much harder to get direct exposure unless you take the self-directed IRA route.

It is no coincidence that Global Trend Capture incorporates commodities and currencies in the mix.    These instruments trend very well and provide a much better option than only trading the U.S. markets, German markets, Asian markets, solar stocks, bank stocks or tech stocks.    The larger our net we drop in the water the better our chances of landing that whale of a trade.

By the way, that is just an expression… don’t send a team of Green Peace volunteers to picket outside of my home.

Let’s face it, you can stare at a bowl of pea soup for hours and it will still remain pea soup (and still taste awful).   You have to get up from the table and venture into the pantry or outside to a restaurant if you want other options (trading wise).

In the end I was lucky to have not suffered more damage to my capital account when I first traded commodities.    I was also lucky to have had it lead me down the paths it eventually did.   Without that experience I believe I would still be investing with a buy and hold approach or simply parking my retirement in the awful recommendations of the 401k providers.

Funny story about that, I traded my wife’s 401K during 2011 and earned a 20% return (which I was very satisfied with considering the challenging environment).

She actually received a letter “warning” her about her allocations.    You see I kept all her money in a guaranteed income fund and then transferred into the limited sectors available (through mutual funds) as they broke out per my system.

Had I followed their recommendations she would have barely earned a positive return (if not a loss), yet she was URGED to get things back in order.     I want to pound my head against the wall sometimes when I think about the investment advice given to people on a daily basis.   If nothing else, I hope I at least get you to think and learn on your own, the same way I did when trading commodities.

Nathan

So what are some of the consequences of living in a zero percent world? And what does it mean that it could last another three years?

• More punishment for savers (especially the elderly). The pain will continue for those on fixed incomes, with nonexistent rates of return for traditional safe savings instruments. If your grandmother isn’t willing to move out on the risk curve, she’ll probably lose ground to headline inflation (the total inflation number including food and energy, which the Federal Reserve ignores).

• Increasing social inequity (and rising social unrest). The U.S. economy has been laid low by the excesses of the leverage and debt supercycle. The aim of current policy is to heal the economy on the whole, but the medicine of cheap credit is only good for those who can tap it. This feeds a widening gap between the “haves” and “have nots” on Wall Street and Main Street.

• A growing obsession with dividends. With interest rates near zero, there is a broad investor consensus that conservative, high quality dividend stocks are the place to be. A 5% return looks great in comparison to the doldrums of a money market account. But a herd mentality risks disappointment for those who chase too aggressively, or forget that no dividend is true protection against sharp downside decline.

• Compressed money manager returns. Investment returns in general are likely to stay compressed, especially in comparison to the “good old days” of expanding leverage and economic growth. When short-term savings rates are meaningful (say 5% or more) and economies are booming, it’s far easier to deliver double-digit absolute returns. But the more we hug zero, the harder it is to tack on each percentage point of gain.
  

• High speculative premiums for growth. With fewer areas of the market looking exciting, the handful of industries and companies with true growth prospects will continue to get more attention. It’s the principle of limited supply relative to pent-up speculative demand at the margins. This means an exaggerated cycle of booms (and busts) for the Netflixes, Amazons, Facebooks and so on.

• A schizophrenic forex market. The U.S. dollar is the Rodney Dangerfield of currencies — it gets no respect. And yet, the euro is a basket case, the yen is a demographic timebomb, the pound is recession prone, and the commodity currencies (Aussie, Canadian etc) are tied to a China growth bubble. The $USD has two ways to win: 1) As a result of U.S. led recovery, or 2) as a result of “risk off” capital flight (out of overseas assets, back into treasuries etc). But the Fed’s willingness to play whack-a-mole every time the dollar index lifts its head will keep the picture muddled.

• A favorable hard asset profile. Gold is dismissed by traditional value investors because there is no effective way to value it (and no cash flow or dividends to accumulate). But gold is a useful form of insurance against central banker screwups… and in a zero rate world the lack of dividend is no handicap. Other hard assets that function as “stores of value,” in comparison to debased paper currencies, could also see new upside along with signs of global recovery.

• Continued trading emphasis on income and mean reversion plays. In 2011 the majority of big trends were killed in the cradle. At extended levels both higher and lower the markets showed a clear tendency to reverse, retrace, and then reverse again. This choppy, trendless action favored mean reversion strategies — fading at extremes — over trending one (buying breakouts etc).

There are bound to be some curveballs in 2012 (and some big surprises too).

Our game plan is to continue hunting for major trend possibilities, but to augment that process of “big game hunting” with an overlay of income generating mean reversion type strategies in this confused, government manipulated environment.

JS

So it was only natural last week to see equities slow their advance, and trade a bit lower on Thursday and Friday.  Fundamentally, the minor pullback was blamed on a disappointing GDP number that showed growth below expectations.  But the technical overhead resistance likely played a big part in the decline as investors lighten up exposure that has finally reached profitable levels from purchases halfway through last year.

This week, we turn the calendar page to a new month, and continue to sort through a full slate of earnings announcements.  We’ve all read the Trader’s Almanac statistics about how January sets the tone for the entire year, and how the US election cycle creates a bullish background for equities this year.  At the same time, economic uncertainty both domestically and abroad create plenty of overhead risks that offset the “statistical advantage” of a positive January in an election year.

All of these cross currents make for a very active trader’s market.  New pieces of information are coming to the market daily, and being interpreted different ways by different parties.  Long-term decisions invest in growth initiatives may sacrifice short-term performance (as in the case with Netflix Inc.).  A Greek restructuring may force debtholders to take a haircut, but lead to a more stable environment.

From our perspective as traders, we’re much less interested in forecasting how the trends will ultimately play out – and more interested in capturing profits from the price swings along the way.  This falls in line with our theme of “being right versus making money.”

This week, we are watching the overhead resistance levels carefully, and focusing more on positions that have room to run before hitting key technical barriers.  Fertilizer producers, gold stocks, and steel manufacturers all have plenty of overhead room before hitting the 2011 peak areas.  There are also some good shorting opportunities setting up, should the resistance areas hold.

Below are a few of the areas we are most interested in this week…

Fed Juices Precious Metal Stocks

Last week, Ben Bernanke and Co. announced that they were committed to keeping interest rates at historical lows well into 2014.  The Fed’s action cleared the way for gold stocks to ramp higher…

This new rebound for precious metals – and the companies that produce gold and silver – comes at an interesting technical juncture.  Since mid 2011, precious metals have been in a bearish pattern as the dollar strengthened and institutional investors gained more confidence in “traditional” equities.

Four to six months of fading action has helped to cool the gold bugs’ enthusiasm and reset the sector from a technical perspective.  But with rates staying at low levels, and the Fed keeping its options open for more bond purchases, inflation concerns are once again rising.

The current environment is especially interesting for silver which has the qualities of both precious AND industrial metals.  The broad economy continues to grow (albeit more slowly than expected), which drives demand for industrial metals.  At the same time, inflation concerns drive demand for precious metals and silver fits both of those profiles.

The Mercenary Live Feed now has a number of positions in this area including a covered call setup mentioned in last week’s View From the Turret along with a few swing trades in precious metal miners.

As spot prices for precious metals ramp, small and mid-cap miners will benefit more than their large-cap brethren.  Typically, blue chip producers have distribution contracts and hedges in place to insulate themselves from price swings.  But small cap producers are more likely to be able to raise funding for additional development based on higher gold and silver prices – not to mention enjoying higher margins on current production.

The Market Vectors Junior Gold Miners (GDXJ) is a good proxy for small and mid-cap gold miners, and also includes exposure to silver producers.  More importantly, a list of the ETFs components is a great place to shop for individual producers with good chart patterns and strong fundamentals.

Middle Class Retailers Compete With Discounters

The company plans to make massive cost cuts (likely including a significant number of layoffs), and also beef up their marketing budget to drive more traffic.

JCPenny’s move is just one example of retailers moving down the value chain, catering to the budget-conscious consumer and abandoning the middle class market.  It’s clear that more consumers are falling into this category (which is why retailers are serving this market), but more competition will reduce profit margins for the entire area.

Deep discounters like Family Dollar Stores (FDO) have had good success over the last two years as consumers have migrated to cheaper outlets for goods.  But now that the major retailers are encroaching on their territory, the advantage may be lost.

FDO has begun to trace out a topping pattern.  Last week’s rally up to the 50 EMA (after falling early in January) sets up an interesting short opportunity.  With the broad market running into resistance, FDO looks like an attractive short to help counterbalance bullish exposure.  It’s one of the names we are watching carefully this week.

Natural Gas Producers Vulnerable

Last week, Jack offered a contrarian perspective to the recent natural gas spike.  Judging from some of the emails we received, the piece hit a sensitive nerve for a number of traders.

This month, our Global Trend Capture service took a nice profit on a bearish natural gas trade, and the area still looks ugly from a technical perspective.

Natural gas producers face an interesting dynamic in that they are able to produce more gas because of shale fracking techniques, but low prices for natural gas makes it more difficult to justify the drilling programs.

The First Trust ISE Reserve Nat Gas (FCG) ETF is a good proxy for natural gas producers – and the chart has been setting up a series of lower highs since the October rally.  A break from this point would catch natty bulls off-guard as many believe we simply can’t go lower from here.  A forced liquidation or panic flight could give the bears a pretty nice short-term trade – and the action could ultimately set an unexpected floor for the group once the last of the weak holders are flushed out.

Options Spotlight

This week’s screen from the Mercenary Options Dashboard includes covered call setups that have a 70% probability rate of being assigned, expire in 50 days (the March contract), offer at least a 2.5% rate of return, and offer 15% downside protection at a minimum.

There were a number of attractive trade opportunities that fit this criteria, but Walter Energy (WLT) caught my eye particularly.  The company makes coking coal which supplies the steel industry.  This trade fits in with our bullish steel positioning, and offers a 19% annualized rate of return with a breakeven point at a clear support area on the chart (well below the current price).

Walter Energy hasn’t reported fourth quarter earnings yet, so the report adds additional risk to the covered call trade.  But WLT will likely trade more on expectations for global manufacturing – rather than on past performance for the company.

The overall market is opening soft this morning due to more concerns in Europe.  Watch for the bulls to try to support this market (and manufacture a breakout), but keep that risk managed carefully.

Trade ‘em well this week!
MM

Yesterday’s announcement included a plan to spend $800 million over the next year revamping existing stores, and a budget of $80 million a month for advertising expenses.

JCP’s transition to a low price model is more confirmation of the new retail paradigm covered in our Five Themes for 2012 article earlier this month.  The disappearance of a “middle class” consumer segment has made it extremely difficult for mid-tier retailers to compete.

As a result, successful retailers will have to pick either an affluent target market (premium price, exclusive attitude) or trade down to meet the needs of the 99% (low cost, maximum value).  Retailers that are not already pegged as affluent outlets will have a very hard time breaking into the premium market.  Wealthy shoppers may embrace a new company offering premium merchandise, but it’s very difficult to revamp an existing brand to meet the affluent consumer’s taste.

So from a merchandise and consumer preference perspective, it makes perfect sense for JCP to trade down to a discount model – offering low prices and attracting a more value-conscious customer base.  JCP is targeting $900 million in expense cuts over the next two years, allowing for more flexibility in lowering prices.

The move is logical for JCP.  Investors believe this will be a major turning point for the company.  But there’s a big picture risk that could lead to significant disappointment…

What’s Good for JCP…

Think about it for a second.  Yesterday, JCP rallied 18.7% based on an announcement that the company would adopt a low price model – implying that JCP is now edging toward becoming a discount retailer.

JCP doesn’t operate in a vacuum.  The market pressures that are leading JCP to downgrade their pricing and merchandise are also pressuring Kohl’s Corp. (KSS), Sears Holdings (SHLD), Macy’s Inc. (M), Target Corp. (TGT), and a host of other middle-class retailers.

Everyone understands the challenges that US consumers are facing, and everyone understands how difficult it is to “increase” your branding and trade up to more affluent customers.

So the natural progression this year will be for everyone to compete more and more on low price and implied value – with premium pricing only available for a few select retailers.

JCP is waking up and smelling the coffee.  Their investors are pleased with the new direction.  But JCP is now trading right up into a major resistance area (after pathetic performance over the last five years)

The fact that many retailers are cutting prices, reducing expenses, and focusing on gaining market share from budget-conscious shoppers is great news for the average consumer.

Despite the fact that the Fed is fueling inflation concerns, prices for consumer staples – and even consumer discretionary items – should remain low due to this increased competition.

From a trading perspective, discount retailers are looking more and more like a trap…

Sears Holdings filling the gap but moving right into EMA resistance:

Kohl’s Corp. traded sharply lower as investors anticipate JCP competition:

Can American Eagle keep their niche?  Will they compete on price?

So far this year, the broad market has shaken off any negative news, and the bulls have been able to advance the ball.  This morning’s disappointing GDP report pressured the pre-open futures, but in the first hour of trading, equities recouped most of their losses.

As long as sentiment remains positive, retail stocks are likely to continue to hold up relatively well.  But unless overhead resistance is broken, many of these charts are setting up for great short opportunities.

We’ll be monitoring the action carefully and reporting trades in real time via the Mercenary Live Feed.  With the Dow in striking distance of the 2011 high, a retreat could be in the works for the next week or two.  Keep retailers (traditional discounters and new to the party discount retailers) on the radar and watch for continuation moves lower.

Trade ‘em well!
MM

On Wednesday the Fed revealed plans to keep interest rates near zero well into 2014, and refused to rule out more bond purchases.

(Einstein once defined insanity as doing the same thing over and over and expecting a different result. These guys must think they’re smarter than Einstein.)

As might be expected, the $USD took a dive on news of the Fed’s actions. Ben Bernanke wants to remind us of something: He can beat the dollar like a redheaded step child, and he’ll do so whenever we wants.

Equities of course rallied — the Dow reversed to hit its strongest levels since May, up nearly 20% from its October low — and bonds strengthened too on the prospect of forever low interest rates. Gold stocks in particular got jiggy.

There is an old familiar macro theme brewing here: Bad medicine hurting the many, while lining the pockets of a few.

Europe is in crisis, unemployment remains bleak, and the global recovery on the whole is on shaky ground. But all that malaise becomes reason to rejoice when you have a Santa Claus central bank juicing paper assets (and ignoring inflation risk) with the promise of perpetual ZIRP (zero interest rate policy).

Other risk-friendly signs abound: Strong signals from the moneyed consumer class (note Apple’s blowout earnings)… China shifting from brake back to gas pedal… and Europe looking down the barrel of a deflationary recession gun. (When is a printing press not a printing press? When you have to hide it from the Germans.)

It’s the classic policy circle, virtuous for some but vicious for the rest:

• Bad news means bad policy in the form of more stimulus
• The stimulus fails to help (and actually fuels stealth inflation)
• Speculative footballs and inflation-haven assets get juiced
• Wealthy corporations maximize dirt cheap liquidity options
• For the economic masses, life continues to deteriorate
• The powers that be say “not working, more of the same”
• Wash, rinse, repeat (until you get a crack-up boom)

Again, the intriguing play here is gold stocks for a trade. Precious metals related ETFs saw a powerful surge on Wednesday — impressive in relative strength terms — and closed out the day at the top of their ranges.

Gold stocks also have the benefit of advancing from a state of undervaluation. Gold stocks in general have been lousy performers these past few quarters, badly lagging both the market and the yellow metal itself.

Until recently, the weak performance of gold stocks made rough sense in light of a strengthening $USD, an optimistic recovery narrative led by the United States, and an investor taste for growth in a low inflation environment.

Now, though, the dollar has once again been ambushed… the Fed has poured cold water on economic optimism projections, reminding us through their actions that the backdrop is ugly… the global recovery narrative is shifting back to one of globally coordinated loose monetary policy… and the backdrop of perpetual ZIRP warrants a fresh focus on inflation protection.

(If the recovery picks up speed, monetary velocity picks up too, risking widespread inflation; if the recovery stalls, yet more stimulus will be applied, creating even bigger problems down the road.)

There are a handful of individual gold (and possibly silver) names that have attractive basing patterns, coupled with constructive breakout action. Reward to risk is favorable here for a sentiment shift that sticks. We’ll be looking to make some plays via the Mercenary Live Feed…

JS

(That actually happened to me, when a guy at the counter found out I was a trader.)

Thing is, the actual performance of natty has sucked like an electrolux — nearly cut in half over the past year. We’ve got natural gas coming out our ears, thanks to the miracle of shale.

But natty bulls have been getting all hot and bothered this week, as a result of serial over-producer Chesapeake throwing in the towel. Via WSJ:

Taking a drastic step to stem a glut of natural gas that has pushed prices down 45% in the last year, the nation’s second-largest producer said it will slash gas drilling by nearly half.

The move is an abrupt turnabout by Chesapeake Energy Corp., which calls itself “America’s Champion of Natural Gas” and helped pioneer drilling techniques that have opened up swaths of the U.S. to energy produced from shale rock. So much gas-rich shale has been found, however, that federal and private forecasters predict an oversupply will last for years.

Time to load up on natty? Some traders think so. Open interest on natural gas ETF call options has broken a one-year high, and someone put on a very big call spread on Tuesday (betting that the natural gas price will climb substantially higher by March).

Natural gas did make a whopper of a move — nearly 8% — after the Chesapeake announcement. But the backdrop feels sketchy. When oil put in its historic bottom near ten bucks a barrel in 1999, the mainstream media was calling for it to go to $5. IThe Economist featured an infamous cover (which I have framed) that read “Drowning in oil.” In other words, bearishness was at an extreme when oil bottomed. You certainly didn’t have Joe Sixpack salivating.

This natty spike, in contrast, is maybe the most anticipated start to a hoped-for (and much delayed) bull market in commodity history.

And check out how it registers (or rather doesn’t register) on the weekly chart:

Real bullish eh? That ain’t what bottoms are made of… sadly the charts for Chesapeake (CHK) and the Revere Natural Gas Trust ETF (FCG) don’t look much healthier. The much loved shale producers have been hammered by the ongoing gas glut.

My instinct in looking at the spike (in both CHK and natural gas itself) is to ask 1) how much of it was due to short covering, and 2) what kind of firepower do the bulls have?

Large volume events often mark the beginning and ending of moves, but in this case the volume tell is skewed by the prevailing bullish sentiment for gas on the retail side.

If we get a winter weather cold snap, more bullish excitement could provoke a further squeeze — as could a crude oil conflagration due to Middle East tensions. But those are a gambler’s hope and I’d be inclined to stay away… too many bullish eyes salivating over natty here.

A further run-up to short-term overbought levels might invite shorting opportunity on vulnerable producers with ugly charts.

JS

Apologies for the delay in this week’s VFTT…

So far this year, the overall market has traded with a significant amount of resiliency.  Despite ongoing uncertainty from Europe, weak manufacturing data from China, and growth concerns in India, equity prices have continued to advance.

This is a welcome shift from last year’s environment of constant shifting between “risk on” and “risk off” – with few trends, sector differentiation, or sustained trade opportunities.  Today’s Teflon market (bad news doesn’t stick) makes sense as managers scramble to keep up with benchmarks, and its not surprising to see high beta names being accumulated.

While two weeks ago we had the “official” start to earnings season, this week earnings reports are picking up momentum with dozens of names reporting each day.  The information flow gives us a good chance to evaluate both fundamental and sentiment strength.

The key in this environment is to look at not only the data being reported, but more importantly the reaction to individual company releases.  Just because a company “beats expectations” doesn’t mean the stock will shoot higher.  Management guidance, whisper numbers, product commentary, and a myriad of company-specific items can affect the trading reaction.

Our trading book is now almost exclusively bullish (with a short euro trade as our only bearish position), but we still have a material amount of cash and the ability to use leverage if the environment continues to strengthen.  We can shift our exposure quickly if necessary, but for now the reward-to-risk is attractive for adding bullish exposure on pullbacks to support or breakouts from wedge patterns.

Below are a few of the areas we are watching carefully this week…

Biotech Benefits From New Technology

The biotech area has been particularly strong over the past few months as advances in technology are creating new opportunities.  This weekend, Investors Business Daily ran an interesting piece on “biosimilars” – biotech drugs that are similar to the “live” drugs that are currently in use, but more efficient and less costly to produce.

The FDA has indicated that they will be evaluating this new class of drugs with rulings on particular situations expected early this year.  Approvals for particular biosimilars would open both opportunity and risk as the potential for generic reproduction  could cut profit margins for legacy drugmakers, while increasing profit for generic firms – or increasing volume due to lower-priced offerings.

So far this year, the iShares Nasdaq Biotechnology (IBB) ETF has been a winner with the group breaking to a new high early and following through on the breakout.  At this point, the broad sector is a bit extended and may pull back for a few sessions.

But given the strength over the last several months, a pullback would be more likely to set up a strong buying opportunity barring a major negative announcement from the FDA.

At the beginning of December, the Mercenary Live Feed took a bullish position in Biogen Idec (BIIB) as the stock broke out of a tight consolidation.  The bullish action has been slow to develop for this position, but as the sector continues to move higher, we are able to tighten our risk point and have a meaningful unrealized profit at this time.

Precious Metals Rebound?

As equities continue to rally, gold and silver prices are starting to come out of their slump as well.  The fact that precious metals can rebound despite a relatively strong dollar is a healthy indicator of demand.

Gold prices have recently been associated with a “safety bid” as retail investors and professionals alike have used the yellow metal to hedge against inflation.

But silver prices can have significantly different characteristics.  Silver has become much more of a speculative vehicle – rising when managers are willing to accept more risk, and falling during times of liquidation.  Part of this price action stems from the fact that silver is both a precious metal AND an industrial metal.

Silver has uses in circuitry, medicine, and other industrial sectors; so as expectations for an economic rebound increase, the perceived demand for silver also grows.

Last week, silver prices rallied sharply and crossed above the key 50 day EMA (Exponential Moving Average).  This after the commodity broke to a new low in December and immediately reversed higher.  Today, we could see both short covering as well as organic buying driving prices higher – and a consolidation after last week’s action could set up a nice buy point for later in the week.

Building Materials – Following Housing Trend

Over the last few weeks, we’ve talked several times about the positive homebuilder action.  Sentiment is shifting in this area as housing starts pick up, prices stabilize, and shadow inventory begins to move.

Two weeks ago, Tractor Supply Co. (TSCO) gapped to a new high after pre-announcing strong fourth quarter numbers.  The company will officially release earnings on February 1st, but the preliminary figures were strong and investors bid the stock sharply higher.

TSCO caters to recreational farmers and ranchers – along with a number of small business clients.  Overall rising sentiment for the broad economy has had a positive effect on TSCO’s business, and the company is smaller and more nimble than heavyweights in its industry.  This puts TSCO in a better growth position – making the company attractive to growth managers and institutional investors seeking “high beta” exposure to the construction / machinery industry.

Options Spotlight

Our screen from the Mercenary Options Dashboard turned up an interesting setup for this week.  The ProShares Ultra Silver (AGQ) has a very attractive buy write opportunity that provides nearly 30% downside protection while still yielding more than a 20% annualized return.

Obviously, silver prices have been more volatile lately (hence the attractive option premium).  But with a bullish environment and silver breaking through resistance levels, the reward to risk looks extremely positive.

According to the screen, traders can buy AGQ and sell the March 45 calls against the ETF for a nominal return above 3%.  The expected breakeven point would be $43.22 – roughly allowing for a 30% drop in the ETF before the position turns negative.

With our cash position relatively high, and our perspective turning more bullish, this looks like an attractive place to park some capital as we continue to scout for attractive swing trade opportunities.

Once again, my apologies for the delay in posting the View From the Turret this week.  There are a lot of moving parts to this market and we’ve got our hands full this earnings season.

Trade ‘em well this week!
MM

]]> http://www.mercenarytrader.com/2012/01/view-from-the-turret-a-day-late-and-a-dollar-short/feed/ 0 http://www.mercenarytrader.com/2012/01/view-from-the-turret-a-day-late-and-a-dollar-short/ http://feedproxy.google.com/~r/MercenaryTrader/~3/hSzYzW__ChE/ http://www.mercenarytrader.com/2012/01/trading-from-a-position-of-strength/#comments Fri, 20 Jan 2012 16:51:04 +0000 Mike McDermott http://www.mercenarytrader.com/?p=18614 Editor’s Note: Today we have a third article from Nathan O. – who is the brain behind our newly launched service, Global Trend Capture.  Over the past several years, Nathan has been perfecting his trend following system and generating some very attractive returns.

Today, Nathan offers some great wisdom in terms of setting up a trading system and not allowing emotions or “intuition” lead to poor trading decisions.  Too many would-be successful traders ignore these concepts just enough times to sabotage what would otherwise be a profitable system.

If you’re interested in learning more about the Global Trend Capture service and how you can receive a risk-free 45 day trial, simply follow this link.  I’m confident that you will find Nathan’s comments insightful and applicable to both discretionary as well as mechanical traders.

Trade ‘em well!
MM

Trading From a Position of Strength

As much as I believe in and cover the merits of risk management, taking profits can also be challenging for many traders.

If a trade goes against you quickly and triggers your stop loss then the battle is already over.    There is not anything to do on your part other than chalk up a loss and move on.    If you happen to be stopped out the same or next day that you entered the position you barely even have time to think about the trade.

Managing open positions, especially those in profit, is different in my opinion from a trading psychology standpoint.     The larger your account grows (and the corresponding size of open profits) the easier it is to get sucked into bad trading thoughts.

If you have just taken a few losses or currently have open positions that are red most people have a natural tendency to claim those open profits.     The idea is “If I close out this profitable position now……….”

I am up in my account………

It makes up for those losses I just took……

It will make this month a winner…..

It will give me confidence….

And so on and so forth!   The interesting thing about open profits vs. losses taken is the time they weigh on your mind.

When the market closes on Friday (assuming whatever you are trading is not actively trading during the weekend) you will have the entire weekend to think about those profits.    In a profitable long-term trade you will have months to debate what to do as open profits accumulate.

Part of what helped me early on was to change the way I viewed profits and profitable positions in general.   I realize this may seem strange or a little too “power of the mind” for some of you out there, but changing your feelings or thoughts subconsciously is the best way I know to combat poor trading habits.

Everyone hears “Let your profits run” and similar mantras, but despite this common knowledge many times trader’s actual actions are just the opposite.    They get anxious, fearful and can’t stand the thought of watching those profits disappear.

I grappled with these same issues early on, but solved them in two ways.

• One, I quit viewing actual dollar amounts and began looking at everything in terms of percentages.   Up 2%, down 1%, a monthly return of 6% replaced the words up $20,000, down $10,000 and a monthly return of $60,000”.

• Two, I designed my system to take partial profits and to use advanced momentum trailing stop strategies to protect more open profits.     For me, this conquered the “watching profits disappear” concerns to an acceptable level yet still kept me around for really big moves.      It enabled me to trade from what I call “A Position of Strength”.

Though self-explanatory there are countless examples of doing something from “A Position of Strength”.

On the battlefield the army that is on higher ground is fighting from “A Position of Strength”.    If a job opening has 400 applicants, the employer is working from “A Position of Strength”.     If we disagree about who gets the parking spot and I have a grenade launcher while you have a rubber band………..well you get the point!!

Before we get too excited, let me be the first to admit my approach is not a perfect one, nor do I believe such a thing exists.     It is only perfect from the standpoint that it fits my trading personality and system.

With partial profit targets you give up some return on the really big moves, though I have combated that to a large degree with the Momentum Trailing Stops.    Still, it is always give and take with any profit taking strategies.    Same with initial stop loss strategies – using larger/wider stops will keep you in more trades, while a tighter stop will get you stopped out more.

The reason I term it trading from “A Position of Strength” is that barring any catastrophic event I have locked in profits now (whether through Momentum Trailing Stop adjustments or Partial Profit Targets).

Trading from “A Position of Strength” does not mean I now have some unfair advantage over the markets or they are at my mercy.    It means only that I now have a guaranteed (with normal disclaimers, i.e. major gap opening against my position) profit with potential for more.

I view it the same as pushing a boulder up a hill and finally getting over the top.   No guarantee it will now go down all the way to the bottom but the heavy lifting has been done and there should be no stress at this point.    Worst case maybe you have to climb down and nudge it past a sticking point but you are done pushing it up any more hills.

The simple process of viewing profitable trades from this perspective should help you manage them better and avoid closing out for the wrong reasons.    Closing out a profitable trade just because it has open profits, to offset a losing position or for any other reason than your trailing stop or partial profit target was hit shows a lack of discipline.

Enjoy that your trade has locked in profits, knowing full well you are not going to nail the top or bottom.      Avoid looking at your account balance and booking those profits in your mind on the part not locked in.    Let’s use a real world example below on CRBC that many of you have a position in right now:

Price is in the $13.30 range, but $12.28 is our locked in price.    Don’t start spending those open profits on this position.   We are operating from “A Position of Strength” but we will always have open profits to give up now that our PPT (partial profit target marked by green diamond) has been hit.    There is no way around this.

You must be willing to give up a portion of open profits to allow breathing room for further price advances on this position.    I am however not willing to give up the amount of open profits that standard trend following systems would allow as marked by the purple rectangle.

To me trading from this position should cause no stress or anxiety.    Under normal trading conditions worst case we get stopped out at $12.28 on the remaining position.   This is why the most important part of exits/profit taking is having a plan.    That goes for trading in general!

While you can never control what happens with price, if you know under what conditions you will adjust stops or take profits there is no reason to be nervous.    If you are in this position right now and you are suffering from any anxiety you really have to question whether trading is for you.   Nervous excitement, impatience and emotional instability are ingredients that don’t make a very enjoyable trading experience.    It is typically not a good idea to fly a kite when tornados are present.   You are probably better suited for snail racing.

All joking aside, don’t discount your emotional state and how it can sabotage your trading regardless of your approach.    Having defined exit strategies will help you handle open profits and trade from “A Position of Strength”.

~~~

Young Chuck moved to Texas and bought a Donkey from a farmer for $100. The farmer agreed to deliver the Donkey the next day.

The next day he drove up and said, ‘Sorry son, but I have some bad news, the donkey died.’

Chuck replied, ‘Well, then just give me my money back.’

The farmer said, ‘Can’t do that. I went and spent it already.’

Chuck said, ‘Ok, then, just bring me the dead donkey.’

The farmer asked, ‘What ya gonna do with him?

Chuck said, ‘I’m going to raffle him off.’

The farmer said ‘You can’t raffle off a dead donkey!’

Chuck said, ‘Sure I can. Watch me. I just won’t tell anybody he’s dead.’

A month later, the farmer met up with Chuck and asked, ‘What happened with that dead donkey?’

Chuck said, ‘I raffled him off. I sold 500 tickets at two dollars a piece and made a profit of $998.’

The farmer said, ‘Didn’t anyone complain?’

Chuck said, ‘Just the guy who won. So I gave him his two dollars back.’

Chuck now works for Goldman Sachs.

Carpe Trendum!
Nathan

The steel sector is an area that is improving both fundamentally and technically – so we asked Nathan to share any insight his system could shed on the group.  It looks like a number of good trades are setting up!

If you’re interested in learning more about the Global Trend Capture service and how you can receive a risk-free 45 day trial, simply follow this link or click on the blue banner below.  I’m confident that you will find Nathan’s comments insightful and applicable to both discretionary as well as mechanical traders.

Trade ‘em well!
MM

Special Report: Steel Sector (Technically Speaking)

Recently I analyzed the homebuilder sector from a technical standpoint and showed my approach for rating funds through relative strength/weakness.   The process typically takes only 15-20 minutes once I have narrowed down the choices.   The “narrowing down the choices” process consists of essentially two methods.

Those two methods that help me make a decision are relative weakness or strength (which I covered) and time of consolidation.    For time of consolidation I use weekly charts and we will look at two companies within the steel sector as listed below:

• AA (Alcoa)
• X (US Steel Corp)

Let’s examine each one, compare and I will give my feedback as I did with the homebuilder group.

I honestly believe if you wanted to trade with the least commitment of time (i.e. chart watching) trading break-outs from consolidation on weekly charts would be the way to go.   I know it sounds too simple and boring for the average screen junkie, but this approach by itself is honestly a viable methodology.

It will become clearer within the charts as I point out the areas on interest.    For practice you can pull up any ETF, currency or commodity to see the ebb and flow with your own eyes.

WEEKLY CHARTS

One of the primary benefits of weekly charts is the removal of noise.   For consolidation purposes, weekly charts are a great tool to quickly see what phase the ETF is currently in.   Even if you are a short-term trader, there is probably a benefit to seeing where what you are trading is at in the big picture.

For instance, if your price is hitting the bottom of consolidation on the weekly chart it may give a better probability of a long trade set-up (per your approach or system) vs. only focusing on the 5 minute or hourly chart to make your decision.

Even though I don’t make predictions or pretend to know where price is headed, if anyone asked me for an opinion on a sector, ETF or ETF within a sector the first thing I would do is pull up a weekly chart.    Every bonus trade offered through the Global Trend Capture service was found by viewing weekly charts.      I consider it one of the best screening tools available to trend traders.

TIME OF CONSOLIDATION

The tighter and longer the consolidation period the more interested I am in trading that chart.   I like to see months of defined consolidation in as small of a range as possible.

When picking between competing ETF’s within a sector this is one of two primary methods I use in making my final decision.    Let’s bring up the chart of Alcoa (AA) and mark some areas of interest:

The red boxes represent areas of consolidation.   As you can see they don’t guarantee large moves or trends when broken; however, the pattern of consolidation to vertical movement repeats on almost every weekly chart.

Of the three, the second area of consolidation I would consider the best.  This range is much tighter than the other two areas.   I also marked declining swing highs (blue bars) to show the current downtrend on the weekly chart.   Although I typically use daily charts for relative strength/swing high (or low) analysis, the fact that weekly swing lows are being broken tells us Alcoa is currently weak.

The low marked by the green arrow (if/when broken) would make the orange bar a valid swing high.  The current price action on the weekly chart is not in consolidation and therefore I would not be interested at this time in a break-out entry (short or long) for this specific company.

Let’s look at US Steel Corp (X) and compare:

On a stand-alone basis we see that X has the same pattern of consolidation followed by vertical movement.

The first box is very similar to the current price action in terms of consolidation.   It is also somewhat tighter and has my interest.    In contrast to AA we see that US Steel has started putting in higher swing lows.   If I were forced to enter a long position between the two stocks, I would choose X (upon a break above consolidation of course).

It is stronger on a relative basis and also is in a consolidation range vs. a downtrend with no consolidation like Alcoa.    Price could very well break below consolidation, but my systems filter currently wouldn’t allow short trades on this stock.

You may be tired of me saying it, but there is no guarantee price will explode up if the upper range of consolidation is broken.   These are simply tools I use to put the odds in my favor when choosing between competing instruments.    Anything can happen, yet I would take the X long trade (if triggered) every single time over Alcoa based on relative strength and due to the consolidation factor.

SAMPLE TRADE

Below is a weekly chart of CRBC (Citizens Republic Bank) that offered a trading opportunity to the Global Trend Capture subscribers (a trade we are currently in).   You can see what drew my attention to this stock based on the consolidation below:

It doesn’t look as impressive on a weekly chart, yet the stock is up over 9.6% from our entry price.   The stock had over 13-months of consolidation before finally breaking out of its trading range.     We have profits locked in and will ride this one as far as it will take us.

SUMMARY

While there is no way to avoid losses there are methods by which you can increase your odds/probability of a successful trade.    These are a few ideas you can use in your own trading regardless of your approach.    Feel free to contact me with any questions you have on this article at info@globaltrendcapital.com

Carpe Trendum!
Nathan

Along the way, we received a number of insightful questions from readers that Nathan addressed in a special report.  We felt the content was applicable to the entire Mercenary community, so we are publishing the Q&A report along with a more personal message from Nathan below.

If you’re interested in learning more about the Global Trend Capture service and how you can receive a risk-free 45 day trial, simply follow this link or click on the blue banner below.  I’m confident that you will find Nathan’s comments insightful and applicable to both discretionary as well as mechanical traders.

Trade ‘em well!
MM

SPECIAL REPORT: Sharks

1/5/2012

Sharks are amazing creatures. Although I can understand the reluctance for people to join their fan club, I admit I am intrigued by them. They have a presence that is undeniable and hard to truly appreciate unless you have been close to one. I don’t mean close as in “best friends”, but in terms of proximity. I think they get an undeserved reputation overall, but there is another kind of shark that I view with much more concern.

I admit lawyers have served many important roles in my career, trading and personal life. I also have to be fair and state that many times they only act out the wishes of their clients. Some of the most brutal attorneys are the nicest people you could meet outside of the courtroom.

That being said, I had a recent experience (lasting several months during 2011) that really questioned my faith in our legal system. You may have noticed that my company name is now known as Global Trend Capital (www.globaltrendcapital.com) vs. the prior name. I will avoid the specific details of the case, but let’s just say when a company has deep enough pockets the issue of right and wrong (along with common sense) goes out the window.

There was a time when most business dealings were cemented with a handshake and a person’s word. Any issues were brought to the forefront and typically resolved without the use of third parties. I realize those days are gone, but whether attorneys were used or not there was a professionalism that both parties understood and followed. The idea of picking up a phone and discussing issues has gone to the wayside.

Anymore it is more common to receive certified mail with demands and consequences layered with threats if those demands are not met. It reminds me of the park bully (in step with his older brothers) that insists on using the merry-go-round you and your friends are on vs. the two others that are unoccupied. It is simply a show of force for no legitimate reason. Without the older brothers (or unlimited funds for legal in my case), we are on even ground and no one has an advantage.

One of the problems with our legal system is by winning you can still lose. What I mean by this is that if I do everything right and ultimately win it could cost a minimum of $200,000 in legal fees. A larger company can bleed you dry to make it not even worth the time and cost to stand up for what is right.

On one hand I am impressed that I am viewed as a threat by the big guys. The fact that they are insecure enough that my company worries them is a compliment to what I am doing. On the other hand the tactics employed by this group to force my hand were unspeakable and shocking. Again, I can’t go into details but I can tell you there is very little that shocks me in this world. This was one on those exceptions!

To be honest I think the new name fits in better with what I do and describes my company with more accuracy. I trade a global macro approach to the markets including Indexes, Sectors, Commodities and Currencies. I have my own version of a trend trading system to accomplish this and the ultimate goal is to grow my Capital (until such time that I manage a fund).

It really just comes down to the principle of the matter and the way in which it was handled. The honor and integrity that was at the heart of businesses is much less prevalent than it was years ago. My business and trading will never be run in such a manner and I would shut the doors in an instant if it ever were the case.

On the positive side, I am grateful that there are still companies out there that “get” it. Mercenary Trader is one of those few companies that has integrity, character and “gets” it. I also want to thank the attorneys at Troutman Sanders (Rob Madayag and Rich Rimer) for their great counsel in this matter. They went out of their way to really provide solid representation vs. a quest for billable hours.

I suppose this is more of a rant or something I needed to get off my chest more than anything else. Life is too short to waste precious time and resources on areas filled with negative energy despite my stubbornness.

My first instinct in trading may be to take the quick loss, but in these matters my normal course of action is not to stand down. Maybe it is a sign of maturity on my part (though my wife may say that is a stretch), as though I prepared for battle initially I came to my senses in the end. It reminds me of the importance of taking a loss vs. holding on out of stubbornness. Despite the fact that I was in the right, the “position” was a losing one and made no sense to hold any longer.

This is the long version of the story behind the name change. I always believe things happen for a reason, so onward and upward fellow traders!

Nathan

Global Trend Capture Q&A

I have to admit I was a bit surprised at the overwhelming response I received on the Sharks article (rant).   Whether it was a case of hitting a common nerve (as in others had similar experiences in their life) or just putting my thoughts out there without the benefit of my brain to filter them, I truly appreciate the feedback I have received on it.

I honestly almost didn’t send it for fear of it being taken the wrong way.   Responses like ….”I didn’t sign up to hear you cry about mean attorneys, I want signals and trading info!!!” or…. “Create a personal blog if you want to cover non-trading issues” were kind of expected.     Not saying some of you were not thinking that, maybe you just didn’t send a response…….ha.

Either way I wanted this piece to cover trading related topics but in more of the same vein as the Sharks rant seemed to do.

Instead of covering entries, exits or money management directly I thought I would post what I thought were some great questions I have received some people.   Some of these were emails and others were in person from other traders.    I want to be clear that I am not including these specific questions and my answers because I think my answers are right, wrong or even insightful for that matter.    I am including them for two reasons:

1)      I think the questions were really good

2)      I think my answers were very honest

The reason I think the questions were good is that they demanded some honest answers.   Let’s be “honest”, you can read 100’s of interviews that talk about specific strategies or techniques.   I am not pretending these are not helpful to your trading or valuable, but bear with me on this for the time being.  While I don’t believe anything I offer is life changing I think for some it may be beneficial to get something other than the typical canned answers about trading.      Anyway, here they are:

Was there a specific event or “Aha” moment that made you realize you could trade profitably on a consistent basis?

For me there was never a specific moment or one single event where everything clicked.   It was a slower process that just continued to evolve.

The best way I can describe it would be the act of turning a big block of ice into a sculpture.    Over time I kept chipping away here and there until it finally resembled something.    It was far from a swan or ice fountain but it at least had the resemblance of something other than a block of ice.    That was a big step and I would compare it to a trader getting to above break-even consistently but not necessarily making worthy returns.   Much better than consistently losing, but let’s just say your son or daughter couldn’t exactly tell you what the block of ice had become.

After some more chipping and maybe even a few chainsaw swipes I could actually see a final product.   Maybe it wouldn’t win any awards in a contest, but my kids could clearly see an eagle now from what started as a block of ice.

In trading terms there were two specific hurdles I think that held me back (and not surprisingly they both related to trading psychology):

a) Finally just taking each and every loss

Sure I read the concept a million times and knew it was what I was supposed to do, yet for whatever reason I would have streaks of taking them and then on one or two individual trades I would be convinced if I just held on it would ultimately work out.   Some did, but those that did not wiped out several winning trades.   I would become frustrated, promise myself to not do it again and then fall off the wagon so to speak.

I finally told myself that if I cannot stick with my initial stop losses I have no business trading.   I ran back through prior trading periods and put concrete numbers on a spreadsheet showing the effects it had on my capital (reduced returns).   From that day forward taking my initial stop loss was never an issue.  I had told myself if I lost my discipline on initial stop losses again I was going to kick myself in the twins and resign from trading.

b) Gaining confidence in my system

Going through the ups and downs (along with my equity curve) in various market cycles was very important.

When you reach the point that you believe in your system and truly are confident that after enough trades you are going to be profitable it is empowering.   Sure back-testing is helpful, but it is not quite the same as trading day in and day out with real money.

To me there is no greater feeling for a trader than reaching that point, whether mechanical or discretionary.    When you know your edge will win out given enough trades it removes all the trading demons that tell you to not take signals, to exit too early or take trades without a valid signal.

When you start managing money will you start with family and friends or take a different approach? (this was asked of me by another trader on a plane, who assumed the answer would be yes)

Honestly my answer would be NO.

Why?  That is the traditional and easiest route to get initial funding?

It is not because my relatives wouldn’t have an interest or that I want to keep anything to myself and away from good friends.   I think the world of my family and my friends.

In my years of business I have seen awful things happen with families when it comes to money.    I have financed large projects for companies that started with Brothers as partners and ended with them not attending each other’s weddings.   I have witnessed Fathers and Sons (Mothers and Daughters) stop all forms of communication over deals gone badly (when no one was at fault other than the economy).

Money has a strange way of breaking bonds that seem unbreakable.    I don’t believe money is the root of all evil, but I value family and friendships infinitely more than I value a “2 and 20 payout” from their account growth.

This is a fictitious example, but think of the following.   Your Uncle/Niece/Cousin begs to invest their $250,000 into your fund.  They happen to join during one of the systems worst months (-6%) and they are immediately down $15,000.   The next month brings a 2% loss (another $5,000) and they are down $20,000 in two months.   They are upset, pull their money and the following month the system knocks down an 18% return for the month.

Even though you counseled them on the need for patience and not acting irrationally over a two month period, how do you think the next 4^th of July get together might feel when you are in line at the grill for hotdogs with your Uncle, Niece or Cousin?

I would prefer working with a smaller group of say 20-30 traders or people who have studied and understand the mechanics of trading.

Are you kidding?  All the second guessing by knowledgeable traders, isn’t it better to just have people where the less they understand the better?   That sounds like a Dr. performing surgery with 20 other surgeons in the room!  No thanks.

I get where the person was coming from, but I still view it differently.   If the investor at least understands the mechanics of trading and how real equity curves print I actually view this as an advantage.    To me they will “get” and or understand the approach being taken to get from Point A to Point B.

This goes against the norm to be sure, but I guess I am not traditional in many areas.    I’d rather have traders that are either looking for diversification from their own approach or people that can at least understand the approach.   Maybe they lack the discipline to trade it, but they still buy into the philosophy.    Maybe this business model won’t work, but I will enjoy the process of discovery all the same.

What is the scariest part or biggest fear you have as a trader?

The expected answer would probably be something related to the markets, but since I don’t predict and only react to the markets this not a fear.  I already know anything can happen and while I wouldn’t enjoy a catastrophic event I don’t wake up in sweats about positions I have in place.

To be honest, I would say it is more Trading Psychology related.   Becoming undisciplined or starting to trade with anxiety would be my biggest fear.   Months and years of profits/returns could be wiped out in days with the leverage available out there.

Look at most of the Ponzi schemes/investor fraud cases and you will see that most started out with good intentions and then lost discipline/control in a sort of emotional trading break-down.     Whether showing false returns to mask their underperformance or taking overleveraged bets to try and get back in the black, disaster happened at an alarming pace.    Hence my decision to trade/develop a mechanical system….

If that answer doesn’t get you opening up your check books with initial investments for my fund, then I don’t know what would!!

If any subscribers have similar type questions or others they feel would be beneficial to ask I am open to sharing them with the rest of the group.

Again, you don’t have to debate me on whether my answers are right or wrong (I think everyone’s answers would be different) but I thought I would share some honest answers to a few questions.     I also encourage anyone out there to share their own thoughts to any of these questions and I will report back the responses.    I won’t reveal any names unless you specifically request to use your name.

Nathan

]]> http://www.mercenarytrader.com/2012/01/special-report-from-global-trend-capture/feed/ 0 http://www.mercenarytrader.com/2012/01/special-report-from-global-trend-capture/ http://feedproxy.google.com/~r/MercenaryTrader/~3/xmHhqW6Rx4E/ http://www.mercenarytrader.com/2012/01/view-from-the-turret-widespread-breakout/#comments Tue, 17 Jan 2012 14:37:53 +0000 Mike McDermott http://www.mercenarytrader.com/?p=18478 Welcome to an abbreviated week of trading (in the US anyway)…

Equity markets are following through on last week’s breakout, and the overall sentiment is shifting into more positive territory.  Expectations for an economic rebound are still relatively tame, but investors are more willing to put capital on the line and institutional managers fear missing out on a move more than they fear absolute losses.

This week, earnings season picks up with a number of key financial names reporting – along with plenty of other industry leaders.  Financial stocks took on heavy losses last year, but still represent an important part of the global economy.  As sentiment improves in this sector, the dynamics shift towards a scenario that favors rising price action with relatively strong support.

Financials are still a good barometer for the entire market.  Whether the strength is temporary, or indicative of a longer-term trend, the shift in momentum is bolstering confidence for a number of other key areas.  Last week we noted strength in fertilizer stocks, steel manufacturers, and the semiconductor sector.  Biotech and a number of technology sub-industries are also moving higher.

This will be an important week to determine if the strength can continue or if earnings reports will dampen investors’ enthusiasm for this rally.  Our trading book has picked up more bullish exposure over the last week and while we still hold a relatively light amount of exposure, our bullish commitments are now about double what we are allocating to bearish bets.

Things can shift quickly during earnings season.  Below are some of the key areas we are watching this week…

Strong as Steel…

As sentiment for the overall economy improves, institutional investors are allocating more capital to areas that will benefit from manufacturing, infrastructure, and general economic expansion.  The steel makers represent an interesting opportunity because the industry has contracted so much over the last decade.

The industry has faced reduced capacity as plants have been closed and bankruptcies or mergers have taken out the weaker players.  Lower capacity levels means that a true economic rebound will lead to shortages and price increases.  Companies with inventories or the ability to ramp up production stand to benefit greatly.

At this point, it’s tough to make a full-fledged argument for a robust economic rebound, but just having the possibility enter the minds of investors can be enough to generate significant price action.  A number of steel manufacturers have broken through bearish trend lines and are now trading in more bullish formations.

The Mercenary Live Feed now has two bullish steel positions, with several other names on the watch list that could be added if strength continues.  Nathan O. of Global Trend Capital has US Steel Corporation (X) on his radar as a breakout has the potential for a strong trend.  Stay tuned this week for some exciting news about Nathan’s trend following service!

Over-Priced No-Growth Still Vulnerable

Despite the broad bullish action, there are a number of “growth stocks” that are rallying into dangerous areas both from a fundamental and a technical perspective.  Speculative growth stocks are priced at premium levels because investors expect earnings to grow quickly.  Often, these expectations get overblown.

Often, when the broad market rallies, these growth stocks initially become the relative strength leaders because portfolio managers want high-beta stocks to help them outperform.  The strength in trend can mask a deteriorating business and eventually set up a great opportunity for well-timed shorts.

Netflix Inc. (NFLX) looks like one of those exceptional opportunities as the stock has now traded back up near the point where it gapped down in October.  Keep in mind, this company self-destructed from a business perspective after alienating its best customers and ignoring competitive risks.

Netflix is trading at a fraction of its former glory, but investors are still paying 25 times 2011 earnings for the stock – and this after the company all but announced that they will have NO profit in the coming year.  Netflix is investing heavily in international expansion with the hope that they will be able to come out the other side with a strong profit machine.

At this point, the risks seem skewed against them, and we certainly won’t know the verdict for a number of quarters.  Now that the gap has been filled, “trapped” investors are likely to liquidate and any negative news could send the stock spiraling once again.  The stock is a volatile trading vehicle, but a well-constructed spread trade could limit risk while still allowing for substantial trading profits.

Financials In Focus

Goldman Sachs (GS) reports tomorrow morning before the open.  During the fourth quarter, the stock has etched out a choppy basing pattern with a solid floor in place near $85.

From a fundamental perspective, it’s very difficult to determine the long-term value of this company.  There are simply too many variables both internally (trading profits, tactical decisions etc.) as well as externally (regulatory issues, economic trends, market tone).

But looking at the overall sentiment of traders, it’s easy to see how Goldman could rally sharply just based on confidence returning to the sector.  As long as GS doesn’t completely botch tomorrow’s earnings announcement, the $85 support level should hold, and the stock should set up an attractive long setup in the next week or so.

We’re not necessarily interested in buying the first breakout at this point, but a show of strength followed by a few days of sideways trading could be just the ticket to allocate some trading capital to the long side.

Options Spotlight

Speaking of strength in financials, this week I was surprised to see the Financial Bull 3X Shares (FAS) show up in our weekly options screen.  This week I used the following parameters to look for covered call setups:

• Stock price below $100
• Probability of expiring in the money above 75%
• Expiration in 40 days or less (February expiration)
• Return on investment 2.5% (not annualized)
• Downside protection above 10%

As you can see, FAS has three different setups that match our criteria.  The ETF has plenty of volatility, but the option premiums seem to fully account for that fact.

My favorite FAS setup for this week is using the $61 strike price.  This gives us the most downside protection (the ETF can drop 27.5% and we will still be ok), as I’m willing to give up some return for more protection in this security.

Over the past several months, we have been focused more on the overhanging economic risks.  This can lead to an overly bearish perspective which sometimes gets in the way of making wise trading decisions.

This week, we still need to manage risk carefully, but also pay attention to the signals from the market.  If bearish trend levels are being broken and capital is allocated to more bullish setups, then we need to take notice and adjust accordingly.  Don’t let a pessimistic mindset get in the way of capturing profits during a temporary rally.

Trade ‘em well this week!
MM

Capital raising is one of the most difficult parts of the money management business – and that’s true even for battle-tested veterans! Emerging managers are finding it especially hard to raise institutional funds as their small size prevents them from even showing up on the radar of institutional allocators.

But there are some alternative methods of capital raising that offer opportunities to managers looking to build a professional shop.  Click on the video below to hear an interview with Bryan Borgia – founder of Topwater Capital Partners – and hear how he is allocating tens of millions to individual managers to help them kick off their businesses

(bullet-point outline of key points below the jump…)

A summary of the interview is below…

If you would be interested in an introduction to Topwater – and possibly receiving an allocation to jump-start your trading program – or beef up your assets under management, please fill out the form below or send us an email (allocations [at] mercenarytrader [dot] com).

We can have a quick conversation about how the program works, the payout structure, the pros and cons of a risk-based managed account, and determine if an allocation is worth pursuing.

Best of luck with your trading!
MM

Key Points From Interview:

• Topwater Capital Partners places capital with traders in a “risk based” managed account.
  • Topwater allocates capital into an account for traders to run.
  • Traders put up risk capital which sits in a first / first position.
  • (First to take losses, first to recoup any losses).
  • As compensation for the first / first position, traders are given a higher payout percentage of profits.

• Topwater’s approach to managers is very “hands off”
  • The trader is allowed to focus simply on making money.
  • Topwater handles the setup of the account / paperwork / administrative issues.

• Topwater was created to provide a unique approach to investing in emerging managers.
  • Choosing a manager off a powerpoint presentation is difficult.
  • The model allows Topwater to analyze traders in real-time.
  • Topwater is now able to analyze a deep pool of talented managers.

• Post 2007, it is increasingly hard for new talent to raise capital.
  • Portfolio managers and traders are burdened by regulatory issues.
  • Even established, veteran traders have trouble raising capital for new ventures.
  • The large institutional investors allocate only to the top tier of alternative managers.

• Topwater doesn’t fit with the typical “seeder” model.
  • Topwater does not take a piece of the management company.
  • Topwater does not require a revenue split agreement.
  • But Topwater CAN be the first allocator to a new manager or a new venture.
  • Topwater’s focus is on managers that have the potential to grow into a strong business.

• Bryan Borgia spends the majority of his time talking with existing and new managers.
  • Does not allocate based on particular strategy or trading style.
  • Focus is on whether a prospective manager can take money out of the market.
  • The setup process can be very quick once a trader has been approved.

• Emerging or smaller managers will continue to be challenged in raising capital.
  • From a cost / benefit perspective institutions must allocate $100 mm plus.
  • Large allocators can’t put this much with an emerging manager.
  • It’s tough to “move the needle” so smaller allocations aren’t available.
  • Topwater focuses exclusively on emerging mangers – one of the few small allocators.

Whether you are an individual trader, have set up your own shop, or operate under a larger company’s structure; every trader has to wear multiple hats…

Successful traders must be skilled at a number of different functions including idea generation, security selection, industry and stock-specific research, trade execution, risk management, performance tracking and reporting etc.

Even if some of these functions are handled by an administrative team, it is still important to keep your finger on the pulse of all of these areas to maintain the best returns and lowest amount of risk.

But how do you create time for all of these tasks?  How can you effectively research new ideas, manage an existing book of trades, communicate with clients, and still have time to eat and sleep?

Reader David F. recently posed the question:

Could you recommend or explain how you and jack stay on top of these things in an efficient manner?

As I get ready to jump into the water with my trading, it almost seems as if admin and recon is going to take away from analysis.

Any thoughts on this would be greatly appreciated…

Well, the short answer is that there really is no “short answer.”  Trading is hard work and to do it right, you MUST allocate a significant amount of time to administrative and trade management tasks – in addition to the more “sexy” research and execution functions.

But creating efficient processes to your trading approach can save a tremendous amount of time – and in this business where time truly is equivalent to capital, efficiency is a beautiful thing.

David’s specific questions centered around position sizing, risk management, and time constraints; so today we’ll touch specifically on these issues.  In the future, we can tackle other issues like research processes, client reporting, and other functions.  If you have specific areas you would like to see covered, send an email to admin [at] MercenaryTrader [dot] com…

To begin with, I want to outline a few important terms we use when putting on a new trade, or analyzing our current risk.

• Initial Risk: This is the amount of risk we take when we put on a new position.  The number is expressed in basis points (see Standardized Units of Risk).  Initial Risk represents the “worst case scenario” if a position moves against us and is stopped out for a full loss.

• Open Risk: This is the amount of risk from the current price to our risk point.  Once again, this number is expressed in basis points.  If a long position rallies sharply after our purchase, open risk will increase because there is now more space between the current price and our risk point.

• Locked In Profit / Loss: This figure measures the total profit or loss (in basis points) for an existing trade if it reaches our risk point.  Locked In Profit / Loss is equal to Initial Risk until our original risk point is adjusted.  When tightening a risk point, our total risk on the trade declines.  Ultimately, tightening the risk point above the original entry point (for long positions) results in a “locked in profit.”

New Trade Setup

So each time we set up a new trade for our accounts, we begin the process by identifying our entry point, our risk point (or stop level), and the amount of risk we want to take on the position.

Since our risk is measured in basis points, it can be universally applied to different sized accounts by simply multiplying the number of basis points times the account value for individual accounts.

If you’re trading for accounts with different risk parameters, one solution might be to set up a “baseline” risk level (say 50 basis points for a “full size position”)and then increase or decrease the the number of basis points for more aggressive or conservative accounts.

The formula can be set up in excel and might look something like this:

Note: $ value to risk depends on the number of basis points at risk times total account value

Shares = ( $ Value to Risk / (Entry Px – Risk Point)

It takes a bit of time to set up a position entry spreadsheet to calculate trade size based on price and risk parameters, but the beauty of setting up these formulas is that new trade ideas can be plugged in quickly – making every future trading decision much more efficient.

Simply plug in your entry price, risk point, and number of bips at risk (assuming the account value remains stable or is automatically updated) and the formula spits out your trade size.

For ease of use, the Mercenary Live Feed has a position sizing calculator with these formulas already built in.

Monitoring Changes In Open Risk

Once you have a trade on the books, the open risk for that position will change with any fluctuations in price.  For long positions, if the security moves in your favor, the open risk will increase because the distance between the current price and your risk point has increased.

While open risk fluctuates, the “locked in” profit or loss will only change when you make an adjustment to your risk point.  So if you move a risk point above your initial purchase price, you have already “locked in” a profit on the trade.

Of course there is always the risk that a position will gap through a risk point – and traders should always allow extra room for unexpected price movements.  But from a risk measurement perspective, we consider profits “locked in” if our risk point would cause a position to be closed at a profitable price.

We keep all of our positions in a constantly updated spreadsheet that calculates the open risk along with locked in risk on a position-by-position basis.

Once again, the process of setting up this spreadsheet may be a bit tedious, but the ultimate time savings by having all the information clearly represented is well worth the initial time investment.  Each day, we simply update the current price column – and any changes to our risk points – and all of our risk measurements are updated automatically.

Managing the Portfolio

OK, now that we have the risk parameters measured on an individual position basis, let’s take a look at how this looks for our entire portfolio of trades.

For our managed accounts, we allocate a certain number of basis points we are willing to risk each calendar quarter (more information on this in future posts).  The number may differ based on risk tolerance, but we always track open risk in terms of basis points.

We total the open risk (in basis points) for both bearish and bullish positions and graph the amount in a pie chart to make it easy to “eyeball” our exposure based on the total number of basis points in play for the calendar quarter.  To the right is a recent example:

According to this chart, if we are stopped out of our bearish positions right now, we will lose 246 basis points.  Our bullish trades represent a total risk of 66 basis points, and we have 300 “available” basis points according to the amount we are able to risk in a calendar quarter.

It’s important to look at these numbers in proper context… In many cases, bullish exposure can help to counter-balance bearish exposure.  So if we were stopped out of our bullish positions, one might reasonably argue that our bearish positions would add profit and offset the 66 bips at risk.

But that logic doesn’t always ring true.  For instance, if our bullish exposure consists of “flight to safety” long positions like gold or high dividend stocks, while our bearish exposure is made up of short positions in speculative names, the positions could end up being negatively correlated.

In this case, it might be reasonable to expect that higher price movement in our bearish book of trades (price action against our positions) would coincide with a decline in “safe” stocks.  In this case we could lose on BOTH sides of the ledger.

The point is, you can’t blindly assume that bullish and bearish exposure will naturally offset.  It is important to have a “qualitative” assessment of your trading exposure – on top of efficient systems to monitor the statistical measures of risk.

Creating systems and procedures for setting up new trades, and monitoring adjustments to your current trading book will require time and energy initially.  But ultimately, creating a simple but effective infrastructure for blocking out these processes will pay off long-term by saving time and cognitive energy.

The question at this point is whether the strength in US markets was an indication of underlying strength (not falling even though headlines from across the pond continued to be negative), or if it was simply a seasonal issue with money managers putting new capital to work regardless of the overall economic environment.

This week we should get more clarity as earnings season officially kicks off with Alcoa Inc. (AA) reporting after the close today.  The company already pre-announced restructuring charges last week, and the expectation is for a drastic reduction in earnings as a direct result.  But traders will be listening carefully to the conference call to determine if management can confirm early signals that the global manufacturing environment is rebounding.

Friday’s jobs report offered a few additional optimistic data points, with the unemployment rate ticking down slightly and private payrolls adding more jobs than expected.  With economic reports now coming in above expectations, it wouldn’t be surprising to see US stocks break above resistance levels and run for a few weeks.

Even though overhead risks are still in place, investors have been aware of these issues for some time, and are now dealing with headline fatigue.  A few weeks in rally mode could set up some excellent short opportunities (remember, the risks are still in play), but in the meantime we are approaching our trading from a more balanced perspective – looking for good reward-to-risk opportunities to add bullish exposure.

Below are a few of the areas we’re tracking for the week ahead…

Fertilizers Find Support

Last week’s action in Monnsanto Co. (MON) caught our attention as the seed and agriculture product manufacturer announced strong fiscal first quarter earnings.  The company noted particular strength in Latin America and the United States, and boosted its outlook for the entire year.

Buying Monsanto after a sharp breakout (into resistance no-less) isn’t a very good trade when you consider the risks.  The stock could easily slide back and stop us out without damaging its technical pattern.  But a number of fertilizer stocks look much more attractive.

As a group, fertilizer stocks have declined as expectations for the global economic recovery have become jaded.  A grain glut complete with weakening prices has led to disappointment when it comes to expected demand for fertilizer products.

But over the last quarter, fertilizer stocks appear to have found support and are trading at much cheaper valuations than we saw early in 2011.  Potash Corp. (POT) is now back to a price point below the 2010 consolidation after an unsuccessful takeover bid by BHP Billiton (BHP).

Agriculture prices are notoriously cyclical – and of course fertilizer pricing and overall demand falls alongside crop pricing and production.  Sentiment for fertilizer manufacturers is negative with plenty of room for improvement.  A break above key technical levels such as last week’s swing high – or the 50 EMA – could be a catalyst for traders to pile in.

Steelmakers Ride Manufacturing Optimism

Encouraging manufacturing data has traders eyeing a number of potential sectors for rebound potential.  Steelmakers in particular look attractive as capacity levels have been cut significantly over the last decade, and the remaining manufacturers now operate leaner businesses with potential for stronger margins if pricing improves.

Nathan O. has identified a particular steelmaker as the “chart of the week” in his Global Trend Capture service (currently in a beta testing period).  This morning, we reported a new pending long for a steelmaker in the Mercenary Live Feed as well.

At this point, we’re not holding any position in the sector, but recent action has set up some compelling entry points should the action continue to improve.

Take a look at the Market Vectors Steel (SLX) ETF below.  The sector has rallied sharply off the October low, and consolidated into a narrowing wedge pattern.  Last week, SLX gapped higher to begin the year and a move above this 4-day consolidation would be a positive sign.  Individual steel makers have similar patterns, and may offer more compelling trades depending on the individual company dynamics.

Semiconductors Becoming More Constructive

From a technical perspective the Market Vectors Semiconductor ETF (SMH) is at an interesting juncture.  The security broke out of a wedge pattern and is above the key 50 EMA.  Last summer, the ETF repeatedly tested support just below $26 and that price point has become a rock-solid floor.

A rally this week would trigger a pending long for the Mercenary Live Feed – with a relatively tight risk point in case the breakout does not follow through.  Given our modest bearish exposure at this point, we’re willing to be a little more aggressive on bullish trades, as our overall risk is muted by our profitable short positions.

Option Spotlight

This weekend, I ran a screen for covered calls expiring in February.  As you can see below, the parameters were:

• Stock Price below $150
• Probability of expiring in the money above 75%
• Expiration in 45 days or less (February expiration)
• Return on investment 2.0% (not annualized)
• Downside protection above 10%

There were more than 30 different setups that matched my criteria (with some stocks featuring more than one option strike that met the parameters).  The Direxion Energy Bull 3X caught my attention as the ETF has been consolidating above the 50 EMA after a false breakdown in October.

The covered call setup offers nearly 30% downside protection – reducing the risk in this trade significantly.  A covered call using the February 39 strike price yields a return of 2.28% – or about 20% annualized and creates an attractive opportunity for idle cash sitting on the sidelines.

This week has the potential to be a major indicator for the remainder of the first quarter.  Watch traders’ reaction to earnings news as it comes out for clues as to how sentiment is positioned and which direction it is shifting too.  Don’t let “expectation bias” affect your trading decisions as price action is a much better indicator than any economic or model-based assumptions.

Trade ‘em well this week!
MM

]]> http://www.mercenarytrader.com/2012/01/view-from-the-turret-strength-or-seasonal-effect/feed/ 0 http://www.mercenarytrader.com/2012/01/view-from-the-turret-strength-or-seasonal-effect/ http://feedproxy.google.com/~r/MercenaryTrader/~3/di8t-UBah-s/ http://www.mercenarytrader.com/2012/01/december-retail-sales-a-quick-review/#comments Sun, 08 Jan 2012 17:44:23 +0000 Mike McDermott http://www.mercenarytrader.com/?p=18240 This week we received monthly sales figures from a number of key outlets and the results were very interesting…  The overall level of holiday sales were below 2010 levels but more importantly, there were significant differences between the types of retailers that did well or fell behind.

Last week we laid out five themes for the coming year.  One of the key issues that we outlined was an adjustment by retailers to account for the disappearance of the middle class in the US.

Consumers today are likely to fall into a binomial model with one of two extremes.  Either they are healthy spenders with stable jobs and plenty of discretionary spending power, or they are struggling to keep it in the road and looking for deep value every time they pull out their debit card.

The mixed results this week show that retailers are in fact seeing this dynamic in play and scrambling to adjust to the new consumer environment.  For the most part, retailers catering to the middle class saw disappointing results while chains that are focused on offering deeply discounted merchandise saw gains.  The luxury retail environment may be particularly challenging as a number of mid-tier retailers attempt to “trade up” to compete with the higher class retailers.

From a trading standpoint, it’s important to begin building a list of expected winners and losers in this environment – and then scanning the charts on a daily basis for entry points with good reward-to-risk dynamics.  It’s still a difficult period to buy breakouts or short breakdowns.

The market is still showing too many “reversion to the mean” tendencies.  But isolating names that have already broken out of patterns, and then entering after a pullback or consolidation offers two advantages:

• It creates an entry point that triggers on the second move – when a bullish stock follows through on a breakout, or the opposite for a bearish breakdown.  This second move is more likely to continue in the direction of the trend, resulting in a higher probability trade.

• It creates a more definitive risk point.  If a stock breaks to a new high, consolidates for 5 trading sessions, and then continues higher; a trader can reasonably expect the low of the consolidation to be a significant technical barrier.  In this case, a long position can be entered with a relatively tight stop – giving the entire trade a better “R” – or reward-to-risk probability.

Let’s take a look at a few of the retail stocks that are setting up on either side of the ledger:

Falling Behind…

American Eagle Outfitters (AEO) was one of the primary disappointments on Thursday when the sales figures rolled in.  For both November and December, AEO said same store sales were up 12% over the same period last year.  So far so good…

But the company cut profit expectations for the quarter (which ends Jan 31), due to heavy promotions in the two weeks leading up to Christmas.  Management said competition was particularly intense, so the discounts were necessary to keep inventory moving.

The stock gapped down well over 10% on Thursday and while the stock finished the day at the high end of its range, the technical damage was still significant.  AEO is now well below the key 50-day EMA, and investors are losing confidence as analysts revise their earnings models lower.

Before the sales figures were announced, AEO was approaching the 2011 high and sentiment appeared to be quite bullish.  Considering the dramatic shift, it will likely take time for institutional holders to adjust their positions and for many to liquidate their holdings.  A 3-5 day pause followed by a new leg lower would be an attractive shorting pattern – depending on the bullish or bearish action in the broad market.

Kohl’s Corp. (KSS) is another good example of a “middle-of-the-road” retailer that is floundering in this environment.  The company announced a 0.1% decline in same-store-sales, which was significantly below the positive expectations of 2.2%.  Kohl’s lowered fourth quarter profit forecasts by about 10% and the stock continued to slide.

The casual retailer occupies an extremely difficult are of the market right now.  The company offers “quality” products at an “affordable price.”  The majority of sales come from apparel and accessories – and the “quality” market for these products is shrinking fairly quickly.

From the perspective of the deep discount shopper, Kohl’s products are a bit too pricey.  Sure, the clothes may look a little better – and they may offer a better value if they last longer.  But when consumers are struggling to make the mortgage or rent payment and keep food on the table, true “value” means whatever I can buy at the cheapest price right now.

KSS investors have had a difficult holiday season with the stock dropping 17% from the November highs.  Analysts are still projecting earnings growth for the company over the next year, but confidence is declining – and it’s difficult to justify any premium price for this middle-of-the-road retailer.

Watch for KSS to consolidate, and consider rolling out short positions any time the stock approaches the 50 EMA or a previous swing high.

Relative Strength…

On the positive side of the ledger, we have both the deep discount boxes – along with a handful of luxury retailers that are executing their strategy extremely well…

Ross Stores (ROST) hit a new all-time high Thursday after the company reported December same store sales increased by 9% over last year.  This was significantly higher than the 4% analysts were expecting.

Management increased earnings guidance for  the fourth quarter (ending January 31) and analysts have subsequently increased their expectations for the year ahead.

From a trading standpoint, it’s difficult to jump into ROST right now.  The stock is trading at a relatively high multiple for the industry right now (16 times fiscal 2013 expectations), and with ROST hitting a new high, it’s difficult to find a reasonable risk point for any new entry.

Keep the stock on your watch list, because a pullback to the 50 EMA could offer a great buying spot with a reasonable risk point.  In November, the stock pulled back to $42 – right at the key moving average line – before vaulting 20% in a month.  This is the type of move that allows for high “R” trades, with profits many multiples above the amount of capital initially at risk.

Other deep discounters to keep on the radar list include TJX Companies (TJX), Dollar General Corp. (DG), and Dollar Tree Inc. (DLTR).

On the luxury retail side, Coach Inc. (COH) is setting up an interesting pattern.  The stock has been setting up a wedge consolidation since early November, and the company continues to have success selling its premium handbags and accessories to affluent customers around the world.

COH is trading with a relatively high multiple (15.73 times expected earnings for June 2013 fiscal year), but that multiple can be justified by Coach’s reliable growth.  Ironically, while some consumers are struggling to keep the home fires lit, wealthy consumers are often concerned with “keeping up appearances” – making sure their peers don’t suspect financial hardship.

Since Coach has a truly international presence, they are more diversified than many US or European-based retailers.  A growing affluent community in Asia helps to drive demand for luxury goods, and Coach is taking advantage of this new consumer segment.

Friday’s action pushed COH above recent consolidation and may offer an exceptional buy point.  Considering the way global stocks held up relatively well (despite a new low in the euro last week), stepping into a long position here may be a great trade opportunity.

The differentiation between different retailers makes it difficult to trade this sector from a broad perspective (using XRT or RTH as retail proxies), but it offers tremendous opportunities when looking at individual retailers.  I’ll be keeping a watch list dedicated to a wide assortment of retailers this quarter.  The key is to do the homework before the action breaks – so execution can be efficient and seamless.

Trade ‘em well!
MM

Three…  Two…  One…  Happy New Year!!!

The confetti has barely been cleaned up from Times Square and already traders are throwing their own ticker-tape party.  S&P futures are indicating a sharply higher open as international markets embrace the optimism that comes along with a new year of trading and a clean slate in terms of performance.

Given the uncertainty of the past year, it has only been natural for portfolio managers to limp into 2012 with low levels of exposure and risk kept at a minimum.  Ironically, for under-invested managers, this bullish start to the New Year carries its own unique risk as managers are immediately put behind the performance curve and into “catch-up” mode.

For this reason, fading the early gap may be a dangerous proposition as mutual funds struggle to keep up with benchmarks from the very beginning.  Even on the first day of trading, performance anxiety can be a powerful motivator for chasing the trend.  So there could be a tremendous amount of dry powder behind this morning’s strength.

Looking farther down the road, the environment is still very difficult to handicap.  Economic risks are significant and well-documented.  From Europe to China to the Middle East; growth is either in danger of turning negative, or at best, in danger of disappointing the consensus.

Until this choppy environment resolves one way or the other, we’re much more inclined to pick our spots with specific sectors, or set up spread trades that benefit from volatility decay – rather than making an overall directional call on the market.  But that still leaves plenty of room to pick off strong trade opportunities and take some high-probability income trades to pad our capital until the broad trends emerge.

Below are a few of the areas we are watching closely as we enter a new year of trading…

Homebuilder Rebound

As mentioned in our “Five Themes for 2012” article, the trading environment for homebuilders is undergoing a major transition.  Sentiment has been very bearish for this industry – and rightfully so.  Developers have been dealing with over-supply for a number of years now – and that supply has come from both existing homes as well as a glut of new or partially built homes that builders have been choking on.

It’s interesting to note that the new home market bears a striking resemblance to the luxury retail sector.  Affluent consumers are still interested in buying top-tier new homes, while the lower end of the real estate market is fully saturated by foreclosures and price cutting from the few surviving discount builders.

Luxury home buyers are excellent retail candidates too – which is why we’re starting to see the SPDR S&P Homebuilders (XHB) outpace its sister security, iShares DJ US Home Construction (ITB).

XHB actually has a much larger retail component, and as luxury home buyers furnish and customize their new luxury homes, these retailers are seeing strong sales growth.  The chart for XHB has turned bullish with the ETF trading well above key moving averages and setting up a nice breakout pattern to begin the year.

Social Media Do-Or-Die

The social media IPO fad is hitting a critical level.  Midway through 2011, investors clamored to get their hands on any publicly traded stock that even remotely resembled Facebook or some other digital medium of communication.  This was a classic case of too much demand chasing too little supply (in terms of stock available to buy).

Today, investors have more options to choose from and are looking more closely at the fundamentals of each issue.  Since many of the “name brand” stocks don’t even turn a profit yet (and may take quite some time to get there with competition increasing), the premium price multiples are being called into question.

Facebook and Twitter are still set to come public this year, but by the time these transactions take place, investors may be tired of the social media story.  It will be interesting to see how much demand the underwriters can drum up for these heavy social hitters – and more importantly, how the IPOs affect social media stocks that are already public.

Groupon Inc. (GRPN) has my attention this week as the stock is challenging its $20 IPO price.  Within a month of going public, GRPN reversed its success and briefly broke below the $15 level.  The stock subsequently retook the IPO level but is now flirting with another breakdown.

If GRPN falls below the $20 level for a second time, it will be very difficult for initial investors to justify holding on to a losing position.  Watch for the underwriters to attempt to support this stock, but a short sale is probably worth considering if GRPN is unable to hold this level.

No Middle Ground For Retail

This year, I expect to see retailers picking one side or the other…  Either cater to the affluent, or compete on a discount price level.  There’s very little room to compete in the middle.

Chipotle Mexican Grill (CMG) could find itself in a vulnerable “in-between” state – where its premium food with integrity is too expensive for the lower-end consumer, but traffic from affluent customers isn’t enough to sustain the company’s exceptional growth track record.

The stock is also up against a key resistance area that it has been unable to break for several months now.  If the bullish action to start the year is unable to push CMG above this $345 – $350 range, it could be an excellent spot to initiate a short position with a tight stop just above previous highs.  A failed breakout farther down the road could also turn out to be an excellent inflection point.

New Feature: Option Spotlight

A new feature we are adding to the View From the Turret is a review of potential option trades that represent relatively low-risk / high probability trades.  We’ve been testing a premium tool that allows us to search for particular option setups that fall within specific criteria.

The table below shows a screen for covered calls on stocks trading below $100, with an 80% probability of closing in the money, these setups expire in 35 days (January expiration), offer at least a 2% return over the period, and also offer 10% downside protection in the stock.

First Solar (FSLR) caught my attention as a stock that has recently found support above $30, has negative sentiment with the potential for a shift to a “less bad” perspective, and the covered call offers a significant amount of protection if FSLR continues to fall.

Note in the table above, the covered call setup has a breakeven point of $28.26 – offering 19.45% donwside protection – and yields 2.19% to call – good for a 36% annualized return.

Obviously FSLR is a volatile name in a volatile industry.  But with the options premium trading at a high level, traders can insulate themselves against a significant portion of this risk – and generate a nice return with excess risk capital.

This trading year is going to be full of opportunity as well as risk.  This is good news because it allows the true “risk manager” to outperform peers – and should help not only in terms of positive returns, but also for companies raising capital from outside investors.

Wishing you the best as we kick off another year of trading!
MM

Across the globe, many important variables are in flux.  Economically, we continue to deal with seemingly insurmountable sovereign debt issues that ultimately affect the livelihoods of millions…  Socially, the world is watching to see how political structures in the Middle East continue to evolve, and the death of Kim Jong-il raises many questions for North Korea’s future effect on the rest of the world.

Politically, this is an election year in the US – complete with a clash of perspectives on how to grow the US economy, create jobs, and achieve a more level playing field for the middle class.

As traders, we’re very skeptical of “predictions,” finding little value in analyst price targets for the major markets, or revisions to GDP expectations for the coming year.  These reports may carry some relevance if they lay out alternative scenarios that could cause market sentiment to shift one way or another.  But the actual “predictions” themselves are usually less valuable for a flexible trader.  After all, there’s a big difference between being right and making money.

Turning the page on the calendar and looking at the year ahead, I see five significant themes that will affect market action.  I’m not going to make a “prediction” on any of these themes – but rather lay out some scenarios that could cause price movement (and profit opportunities).  As we trade our way through the coming year, I expect the following areas to be particularly relevant for traders:

1. Europe’s adjustment to overwhelming debt
2. China’s growth engine misfiring
3. Social media “investor market saturation”
4. Homebuilder sentiment shifting
5. Retail adjustment to no middle class

We’ll break out each of these themes below the jump…

Europe’s Adjustment to Overwhelming Debt

I know at this point you must be saying “well duh! of COURSE Europe is a major theme for 2012.”  For the majority of 2011, we saw markets react to European headlines on a daily basis.  The environment was extremely difficult to trade because of the “risk on / risk off” dynamics that were impossible to predict ahead of time.

This year, markets will certainly be influenced by headlines concerning bond issuances, austerity votes, and civilian reactions to political decisions.  But the trader sentiment is much different heading into this year after having a year to adjust to the dynamics.

The EURUSD currency pair has come full circle over the past year – now sitting at the key 1.30 mark.  This is a critical juncture and from a technical perspective, a break of this level could trigger massive liquidation and seriously undermine confidence in the European currency.

While our trading book has relatively light exposure at this point, one of our largest positions is a short EURUSD trade.  We recently doubled our exposure when EURUSD crossed below 1.30 – while simultaneously tightening our risk point to lock in a net profitable trade on the entire position.  ~All trades are time stamped and reported in real-time via the Mercenary Live Feed.

Our view is that the reward to risk ratio is favorable for a sudden move lower.  Of course there is a chance that EURUSD finds support at this critical level, but if this happens, our risk is minimal.  On the other hand, if EURUSD breaks down, our potential profit will be many multiples of the amount of capital we put at risk.

The action in Europe has a direct affect on the financial sector – which is why we have seen so much weakness in the major banks this year.  But given the negative level of sentiment, and the action over the last two quarters, there are reasons to consider being bullish on this sector in the coming year.

Traders are already well aware of the risk that Europe poses to the financial sector.  By the same token, banks have worked hard to raise capital levels and reduce their sovereign debt exposure.  With the worst-case scenario already well researched and in many cases expected, there is now strong potential for sentiment to shift back to more bullish levels.

It wouldn’t take a major bullish event to turn this sector higher.  Traders could cover short positions and asset allocators could bump up their positions just based on a “less than horrible” perspective on the sector.  So any positive news – or lack of new negative catalysts out of Europe could actually propel a bullish move for major financials.

Speaking of Europe and shifting sentiment, let’s take a look at another major economic development that has been flying under the radar…

China’s Growth Engine Misfiring

The Chinese economy has been one of the strongest growth stories over the last several years.  Investors have allocated capital to this area because China has continued to grow even while developed nations stumble.

But recent data points have indicated deceleration in that growth rate – leading to concern over valuations for Chinese equities.  Remember, equities trade (or are theoretically supposed to trade based on long-term expectations of earnings).  When investors believe that earnings will continue to grow at an exponential rate for a long time, they are willing to pay a premium price.

What happens when those growth expectations are called into question?  Even if China’s economy is still expanding, a slower rate will still lead to lower prices as investors adjust their models and premium price points become harder to justify.

If austerity measures are successfully implemented in Europe, it will have a profound effect on China’s export-driven economy.  Bulls hope that the US recovery will drive demand, but this recovery is uncertain at best.  Recent manufacturing statistics out of China indicate growth is slowing, and housing costs have also come in below expectations.

This is good news for China’s inflation problem, but bad news for economic growth.  The developments are taking a back seat to Europe’s crisis, but as the media begins to pay more attention to the developments in China, we could see optimism wane – valuations contract – and stock prices continue to drop.

The chart above shows Chinese equities in a truly bearish trend.  But the media attention has focused much more on the crisis in Europe, leaving China’s bear market as a “page two” event.

If more attention is given to China in 2012, it could significantly affect the trading environment for these stocks, and a climactic event could ultimately give bearish traders an excellent opportunity for profits.  We will be looking for good reward-to-risk scenarios to lay out short positions in both the ETFs that cover this area, as well as individual equities with speculative price multiples.

Social Media “Investor Market Saturation”

Price action is all about supply and demand.  Prices rise when demand outstrips supply, and drop when there is ample supply and less demand.  This is true about commodities, services, and even financial securities.

In early 2011, there was plenty of buzz about the new wave of social media companies coming public.  Investors were excited about participating in this high-growth industry, and well-connected investors were able to gain access to companies like Facebook and Twitter well before the lower-tier companies priced their IPOs.

The IPO transactions ended up with mixed success over the year.  To begin with, LinkedIn Corporation (LNKD) saw a triple digit percentage gain after offering its stock to investors at $45 and seeing the stock eclipse $120 on the first day of trading.  Since then the stock has backed off significantly, but still carries a healthy premium to its initial price.

Part of the reason LinkedIn was so successful was because there were few other social media stocks available to invest in.  But as companies like Groupon Inc. (GRPN), Pandora Media (P), and Angie’s List Inc. (ANGI) were brought to market, investors had more choices for participation in this area.  In fact, Global X even launched a social media ETF to give traders a diversified option for investing in the industry…

As more supply (of stock choices) hit the market, the hype premium began to wear off.  Couple that with competitive challenges for many of the most well-known names, and stock prices began to drop.

In 2012, we’re expecting Facebook and Twitter to come public, along with Yelp and a handful of other tier-two players.  The opportunity for diversification should allow traders to separate companies with good prospects from the “also ran” names – leading to significant divergences between stocks in this industry.

Option prices point to high levels of expected volatility and lead to spread opportunities like the bear put spread we recently traded for LinkedIn.  Expect to see plenty of volatility in social media stock prices this year – with the potential for trading profits through pairs trades or option spreads.

Homebuilder Sentiment Shifting

Another area where we are likely to see shifts in trader sentiment is the homebuilding area…

Purchasers of foreclosed homes are typically either retail buyers looking to pick up a “good deal” – and willing to make their own improvements to the property – or investors buying the foreclosed homes at a discount with the intention of renting or flipping the home.

But new home buyers are now much less worried about price, and much more focused on location, style, and convenience.  These new home buyers want a new home because they don’t want to deal with the hassles of owning a foreclosed property that may have significant improvements that need to be made.

So while the “shadow inventory” of existing homes continues to be a drag on the market, builders are beginning to see a rise in demand for brand new units – and we have seen the economic data point to unexpected rises in both housing starts and new permits over the last two months.

Trader sentiment for this area has been negative for so long, that it is actually hard to imagine being bullish on homebuilders.  But the stock prices for many of these companies have rebounded sharply over recent months, and the luxury homebuilders are seeing more demand as wealthy consumer sign contracts.

Early last year, we took a close look at the differences between the two major homebuilder ETFs.  The SPDR S&P Homebuilders (XHB) has a lot of exposure to retailers serving new home buyers, while the iShares DJ USHOme Construction (ITB) is more heavily focused on the companies that actually construct the homes.  The conclusion we came to at the time was that ITB was a better trading candidate for homebuilders.

But today, that role may be reversed…  New home buyers are typically motivated shoppers as well.  Companies like Pier 1 Imports (PIR), Williams-Sonoma (WSM), and even Home Depot Inc. (HD) are benefiting from the rise in new home purchases.  So a bullish trade in XHB might offer a better return this year as home buyers embrace the entire experience of buying – and furnishing – a new luxury home.

You can see this dynamic in play by looking at the relative return for XHB (red line) versus ITB (blue line) over the last 15 months:

Speaking of retail dynamics, let’s take a look at that sector for the coming year…

Retail Adjustments to No Middle Class

If 2011 was the year the middle class disappeared, then 2012 will be the year retailers adjust to the new environment.

Despite a challenging economic environment, luxury retailers continued to grow earnings in 2011.  This is because the truly affluent consumers didn’t face the same sort of challenges that “normal” people had to deal with.  The unemployment rate for workers used to a six figure salary was significantly lower than the unemployment rate for blue-collar workers, and this dynamic is likely to continue in the coming year.

With the retail environment largely being split into two camps (the “haves” and the “have-nots”), companies catering to the upper or the lower end of the retail spectrum have fared well.  Companies like Lululemon Athletica (LULU) have continued to see year-over-year earnings growth at or above 50%.

At the same time, investors piled into deep discount retailers like Dollar General Corporation (DG) because of their success in capturing market share for “the 99%” consumer.

This year, we will see even more adjustments being made by middle of the road retailers like Kohl’s Corp. (KSS) and JC Penny (JCP).  Just like a high-stakes game of Omaha hi-low, retailers need to cater to one side or the other in terms of consumer classes.

This means that established players on both ends of the spectrum will be dealing with more competition.  Expect significant price swings from retail equities as traders adjust to the new environment and company-specific market advantages are challenged by new entrants trading up or down the food chain line.

Traders With Flexibility Win…

It is clear that this coming year will favor traders who are able to adjust their style and their area of focus based on the changing dynamics of the market…

This year we will continue to look for attractive swing trading opportunities, while also adding new strategies to the mix.  Covered  calls may help to capture option premiums, while pairs trades give us a chance to collect relative value from different securities.  We’re beefing up our research capabilities to cover more industries, groups and themes, and we’re excited about the expanding trade opportunities.

While certain principles like risk-control and selectivity & spread are overarching concepts, individual components of a trading program must adjust to meet the market dynamics.

Here’s to a flexible and profitable 2012!
MM

Not only is this week pared back to only 4 sessions, barring any huge event in Europe, each day should feature anemic volume making it difficult for the heavy hitters to move any material amount of exposure.

The light holiday trading has a natural tendency to create choppy action – and in this environment, short-term chart patterns become unreliable and any trading signals should be taken with a grain of salt.  It’s little wonder that many professional traders take this week off because of the poor reward-to-risk characteristics.

At Mercenary Trader, we’re still manning the desks, but the focus this week is on outlining some of our plans and goals for the coming year.  2011 has been a tremendous year of growth for us, and 2012 will be no different.  We have a couple of new services in development right now – along with some exciting partnerships we are setting up with companies who offer premium trading resources.

All of these initiatives will help to improve the quality of our content, the profitability of our trades, and allow us to cover more opportunities on a day-to-day basis.  I’m tremendously excited about the coming year and look forward to hearing what you think about the new opportunities in the coming months.

For this week, we’re much more focused on managing our existing positions – tightening risk points and watching for pyramid opportunities – rather than aggressively pursuing new setups.  With light-volume choppy action, chart patterns tend to become less reliable and we would rather wait for better conditions to lay out new exposure.

Below are a few trades we are currently tracking – (all actual trades time-stamped and documented in the Mercenary Live Feed)

Stable Dividend Stocks Climb

Despite the bearish overhang and headline risk that has plagued the market this year, stable companies paying high dividend yields have attracted a significant amount of capital.

Part of the draw here is the fact that “traditional” income investments just aren’t paying a material amount of income.  10 year treasuries have been paying only 2% and shorter-term fixed income investments are even lower.  On the municipal side, risk levels are high, but investors aren’t getting paid to take that risk.

A few industries like energy pipelines and consumer staples have natural cash flow that is somewhat independent of the economic cycle.  The stability naturally attracts capital during uncertain periods – which is why we’re seeing natural gas pipelines and tobacco stocks rallying sharply.

We’ve got a profitable position in Magellan Midstream Partners LP (MMP) which has rallied 5% from our November 11th purchase – along with a 4.7% dividend yield.  The fact that MMP has a low Average True Range (ATR) means that we can take a larger position (in nominal dollar terms) because our risk point is much tighter.

With a tighter risk point, we are able to buy more shares with a tight risk point – allowing us to make more profits out of this 5% move than we might otherwise make in a 20% swing for a more volatile position.  For position sizing, the denominator is the capital we will risk before having the trade stopped out – rather than the total amount of cash it takes to buy the position.

At any rate, MMP continues to push higher and our risk point has now been tightened to ensure a profitable trade…

The Sky (Cloud) Is Falling!

Cloud computing has been one of the speculative areas that we have followed all year.  The elements for an implosion have been there from the start.  But until the second half of the year, this sector has held up relatively well.



At any rate, the 50 EMA repelled the stock, and we took a short position just below.  As managers liquidated their risk, we were able to take half profits off the table and tighten our risk point to ensure a gain on the entire position.  Even after the fall, CRM still trades at a premium multiple to earnings and could continue to fall.  We’re also interested in adding horizontal exposure in the coming year – with a number of related stocks setting up good short entries.

Euro Continues To Languish

The European debt crisis has weighed on the markets all year – and the EURUSD currency pair has been in a bear trend for the majority of the last 6 months.

In early November, we took a short position in the euro – after a bullish breakout turned out to be a false move.  Traders who bought into the “all clear” signal became trapped in a losing position.  Their liquidation offered the fuel for a new decline which has taken the EURUSD pair to the critical 1.30 level.

A break of this level would do tremendous damage both on a technical (chart) level – as well as on a psychological level.  We’re currently holding our position with a risk point just above 1.35 and looking to add additional exposure once the currency breaks definitively below this level.

This holiday week is a good time to recharge the batteries, while reviewing high-level trading strategies and goals for the coming year.  Entering 2012, there are still a number of key risks in play – leading to plenty of trading opportunities as markets react.

Trade em well this week and take some time to enjoy friends and family as well…
MM

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