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    • Hedging With a Bear Put Spread: Part 8 of Options Trading for All Types of Market Environments

    Friday, February 10th, 2012

    Investors who are currently in the market may be sitting on some handsome profits, especially if they were astute enough to have started buying late last year.

    The S&P/ASX 200 is approaching the key 4350 resistance level. This level has been a barrier of resistance since last July and investors should be looking to protect their profits. Profit protection can be obtained by outright selling the position, or by buying a protective put, as discussed last year in the article Options Trading (Part 1): The Protective Put.

    However there can be reasons why a long term investor may not want to cash out at this time, such as capital gains tax or perhaps an upcoming dividend. A cheaper alternative to buying a Protective Put would be to enter into a Bear Put Spread, which limits the cost of the protection, but also limits the degree of protection.

    Cheaper Protection Using Bear Put Spreads

    A Bear Put Spread is an options strategy that can be used to buy put options at a discount and can be particularly useful when you have an existing stock position that you want to protect. It is a debit spread that can be an effective way of hedging an underlying share position, as it allows investors to purchase put options at a relatively cheaper cost than an outright put purchase.

    The Bear Put Spread is an option strategy that makes its maximum profit when the underlying stock declines to the short strike and has its maximum risk if the stock rises in price to the long strike. The strategy is to be implemented using puts, where an option with a higher striking price is purchased and one with a lower striking price is sold simultaneously, both options generally having the same expiration date.

    The Bear Put Spread option strategy is established by selling to open an Out of the Money (OTM) put option, which effectively reduces the cost of the In the Money (ITM) or At The Money (ATM) Put options. This reduces the upfront payment and therefore the risk of the position, making it an ideal option trading strategy for investors who want protection from falls in a down market, while holding on to their existing position (hedging).

    Standalone, the Bear Put Spread is a bearish option strategy that profits when the underlying stock price falls. The Bear Put Spread involves simultaneously buying to open and selling to open options of the same expiration month, making it a Vertical Spread and because you need to pay money to put on this position, resulting in a net debit, this is also known as a Debit Spread.

    A debit spread profits from a move in the share price through the purchase of an option near at-the-money (ATM) (or ITM), whilst reducing the cost of the trade by selling an option further out of the money (OTM). The advantage of the debit spread is that the cost of purchasing the option is lowered, while the downside to this strategy is that the profit is capped by the sold options, and this is why the investors must choose their option strikes carefully, so as to attain a good risk reward trade.

    The debit spreads are directional trades as they benefit with an increase in volatility, and as such, a directional move in the share price. Note that if the trader expects a short sharp move in the near-term, then they would be better off simply buying a protective put.

    Recent Trade – Toll Holdings

    A recent trade that our clients took was to buy Toll Holdings around $4.50 in late January. The stock surged 17% in the subsequent couple of weeks. Clients were then faced with the dilemma of taking profits now or holding on for the dividend in early March.

    Toll Holdings Chart in Market Analyser

    We suggested that they could hedge their position using a bear put strategy – by buying a ATM Put & Selling an OTM Put.

    In this trade with TOL trading at $5.20, the bear put strategy was established by Buying to Open TOLL 525 MAR12 Put for 23.5c and Selling to Open TOLL 476 MAR12 Put 7c, for a total outlay of 17.5c (ie. Net debit= 23.5c – 7c).

    Note if you were more pessimistic and expected TOL to fall to $4.50 by expiration, you would have sold the 450 MAR12 Puts.

    Payoff Diagram for the Bear Put Spread

    Risks and Profit Potential

    The Bear Put Spread profits when the stock price falls towards the short strike, as the long put option will rise in price along with the underlying stock price, while the short put options continue to decay in premium. The maximum profit potential of a bear put spread is when the price of the underlying stock drops down to the strike price of the out of the money (OTM) short options, as beyond that price any gain in the long put options is matched exactly by a loss in the short put options.

    Profit Calculation of the TOL Bear Put Spread:

    Maximum Return = (Difference in strikes – Net Debit) ÷ Net Debit

    Following up from the recent trade example:

    Buy to open 10 TOL MAR12 525 Put for 23.5c per contract and sell to open 10 TOL MAR12 476 Put for 7c per contract.

    Maximum Return = (525 – 476 – (23.5 – 7)) ÷ (23.5 – 7) = 31.5 ÷ 17.5 = 180%

    Maximum Risk = Net Debit = 23.5c – 7c = 17.5, if TOL share price is > $5.25

    Break Even = Higher Strike – Net Debit = 525 – 17.5 = $5.075

    In summary the Bear Put Strategy offers a maximum risk limited to the Net Debit Paid, while the maximum loss is limited and the maximum upside profit is also limited. These risk/rewards are shown in the Payoff diagram.

    Note this strategy can be used in order to hedge an underlying Toll Holdings stock position, while the investor is still eligible for the dividend payment in early March.

    The Trade

    Options can be used in order to reduce/hedge your risk, while still participating in potential profits from a significant move by the underlying stock. We have explained the Bear Put Spread strategy which can be used to allow you to protect an existing share position, while maintaining the benefits of ownership of the underlying stock.

    In future articles we will talk about the High Yield Covered Call strategy and the Covered Call Stock Reversal strategy which is particularly relevant to this market.

    Utilise the features in the Market Analyser software to plan your options trades for a particular options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk.

    By Michael Hevern
    Trading Desk

    ** Please note your may need to refer to a tax profession regarding eligibility of franking credits.

    See Also:

    Options Trading for All Types of Market Environments (Part 1): The Protective Put
    Options Trading for All Types of Market Environments (Part 2): The Covered Call
    Options Trading for All Types of Market Environments (Part 3): The Covered Call Collar
    Options Trading for All Types of Market Environments (Part 4): The Stock Repair Strategy
    Options Trading for All Types of Market Environments (Part 5): Limited Risk Short Selling Strategy
    Options Trading for All Types of Market Environments (Part 7): Dividend Capture Covered Call Collar

    For Buy and Sell recommendations on ASX listed companies register for a FREE trial of MDS Financial Research.

    MDS Financial Advisory Service offers general advice on trading options to generate consistent steady income on your investment portfolio. For further information please call 1300 610 024.

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    Three Fatal Trading Mistakes

    Friday, February 3rd, 2012

    There are a wide variety of mistakes you are likely to make while learning to trade, but there are three mistakes you had better learn to avoid very early in your trading career. Before you start trading you must verify your trading strategy works by testing it both historically and on real-time data. Controlling the size of your losses is essential and without sound risk management you’ll never trade successfully. But controlling losses is not enough; you must also resist the temptation to over trade. Any of these three mistakes can be fatal to your trading success.

    Trading untested ideas

    Poor analysis or research is common among new traders. You may hear a news report about a particular company and decide it would be a great idea to trade the company based on the report. Unfortunately by the time the news gets to you many other people already have the information and have made their trading decisions. There’s a saying in the stock market: ‘buy the rumour, sell the fact’, meaning that when the news is finally released it’s very often too late to enter a trade. Following tips or rumours is a sure sign that you haven’t adequately prepared to enter the market. By doing your own analysis you can determine what works and what doesn’t.

    Back test or forward test your trading idea before ever entering a trade. Back testing involves testing your idea on historical data and allows you to test a large number of ideas very quickly. For example, you may scan a lot of charts and identify a particular pattern that appears before significant moves in a share. This is back testing.

    Forward testing (often referred to as paper trading) involves testing your idea on current data as it becomes available. To verify that your idea works, look for opportunities as they unfold because your chosen pattern may occur without a strong move following it. This is using forward testing to confirm your idea. Forward testing is more reliable than back testing, but much slower to perform.

    In its simplest form you can back test by looking at lots of charts so you can begin to recognise patterns that occur before a strong move unfolds. When I started trading I studied thousands of charts to find out what worked and what didn’t, then narrowed down a few ideas to follow through with forward testing to see if they continued to work. Ensure you complete a thorough analysis before entering a trade, or follow a more experienced trader’s strategy.

    Allowing losers to get out of control

    Failure to cut losses can quickly result in disaster for any trader because the market can move far more than you expect. This is probably the most common mistake we see new traders make. The trader hopes the trade will reverse direction and move back into profit. Refusing to take the loss, the trader continues to hold the trade while willing it to turn into profit. While this may happen occasionally, when the trade doesn’t turn around it can do severe damage to your trading account. Cut your loss and look to re-enter if another entry signal appears. Ensure you develop the discipline to enter a stop loss into the market every time you enter a trade. This ensures you never get hit with large losses.

    Mental stops are stop-loss orders that you place in your head instead of the market. For example, you decide to exit a long trade at $3.10, but when the market approaches $3.10 you convince yourself the market will move higher soon so you don’t take the exit as planned. The loss can now get seriously out of control and you could lose a lot of money. The problem with mental stops is you have to act on them. This can be difficult because when you are required to execute the trade you’re often in a losing position and hoping things will turn out ok. Even if you have been able to develop the discipline to act on your stops, the market sometimes moves very rapidly and you may end up losing more than you expect.

    Mental stops may be used by experienced traders, but must never be used by beginners. Until you master the discipline to take exits when they’re signalled, stay well away from mental stops. Focus on good stop placement to avoid getting stopped out.

    Overtrading

    Another common mistake traders make is overtrading. It’s possible to make very nice annual returns from just a few good trades a year. High frequency trading is not required to make a profit. If your strategy has a sound edge then the more opportunities you have to trade it the better, but don’t confuse trading a lot with trading successfully. A few good trades can make a good year. It’s not necessary to be in and out of trades 20 or 30 times a day to make a profit.

    Some of the most valuable time you can spend is identifying the best opportunities. There are millions of trading possibilities. It becomes necessary to make some choices and narrow your selection of what you will trade. To do this it’s necessary to overcome the fear of missing out on an opportunity. Remember the opportunity of a lifetime comes along every week! Many great opportunities will appear, so stop wasting your time and money on half-rate opportunities. Accept nothing less than the best when selecting trades. This
    more selective approach can dramatically improve your profitability.

    Eliminating mistakes

    Eliminate these three fatal mistakes we’ve just discussed and your trading will improve dramatically. However, to eliminate the mistakes, first you must identify when you’re making a mistake. Your trading diary where you record your trades, wins and losses allows you to identify areas where you’re failing to stick to your plan. In particular be honest about the reasons you entered a trade. This honesty may take some time to develop because it’s not nice to admit you took a trade because you wanted to make back the money you lost in the morning. It’s easy to justify that a setup was in place, but tell the truth. You’re only lying to yourself.

    Identify why you fail to stick to your plan and what you must change to eliminate the mistake. If the reason you fail to execute the core skills is emotionally based then monitor how you’re feeling when you’re trading and notice when particular emotions appear. Address each bad habit, one at a time, to change your behaviour.

    Refining your trading skills takes practice to improve on the areas in which you’re weak, but the rewards are worth the effort. Becoming a better trader requires you to become a better person. This is one of the reasons you can find trading challenging to learn. Fortunately once you’ve changed a few habits, successful trading becomes much easier.

    Jeff Cartridge
    Education Manager

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    Core Trading Skills

    Friday, January 20th, 2012

    There is a series of core trading skills that you will be required to develop to trade successfully. Mastering these core competencies is essential to mastering trading. The core skills start out with analysis, first and foremost. Following this the position size is determined in conjunction with your entry criteria and your stop placement. By religiously placing a stop on every position, you cut your losses, but still have to work out when to take profits. Scaling in can be used by intermediate traders to reduce the risk when entering a trade and scaling out can be used to lock in profits as they occur. And then one final skill to master is re-entry after you have been stopped out or taken profits on a position. It does not matter whether you trade shares, currency, futures, commodities or CFDs, the core skills required are all the same.

    Analysis

    Before you place your first trade you must decide how you will develop a trading edge. Your trading edge is your advantage that you intend to exploit for profit and is critical to your success. Your edge will come from a thorough analysis of the market you intend to trade. It is not essential for you to do all the research yourself as you can utilise analysis from a third party, but it is essential that you find an edge before you enter the market.

    Methods of analysis can include a wide range of variables including economic factors, technical indicators, seasonal influences, fundamental criteria, relative performance, news releases, special events and valuation measures. It does not matter which school of analysis you subscribe to as long as the method of analysis provides you with an edge.

    Position Sizing

    Sound position sizing methods are critical to your trading success. It is essential to size your positions to control losses. No matter how good your analysis is, YOU WILL BE WRONG. Accepting this is important to survival when trading. The market you are trading is made up of thousands of participants all making independent decisions. No analysis available can take into account all the possible outcomes of these individual decisions, so no analysis will be right every time. If you have placed too large a position on the trade then you can blow up in spectacular fashion as the result of a strong move or gap against your position.

    Low Risk Entry

    Low risk entry points improve your chance of success when trading. A low risk entry point means you will lose very little if the trade does not go as planned and by keeping your losses small this can improve your risk reward ratio and your overall profitability. There are a variety of methods for determining a low risk entry point, however with all of these entries you will quickly know if your analysis was wrong. Low risk entry points not only make trading easier, they are more profitable overall, because when a trade does not work out your loss is as small as it can reasonably be.

    Cutting Losses

    Before you enter a position you should know where you are going to get out. This is critical to keeping your trading account intact. When you enter a trade there are only three things that can occur. Your analysis was correct and the trade moves into profit, your analysis was wrong and the trade moves into a loss, or you get lucky and it moves strongly in your favour. We prefer the third outcome and the purpose of our analysis is to identify opportunities where we can get lucky, but more importantly we want to avoid the situation where we get caught with large losses.

    Develop the habit of always placing a stop loss order into the market when you enter a trade, to ensure that you control your losses on any trade.

    Scaling In

    Have you ever entered a trade and realised almost immediately that you did the wrong thing? Most traders have. By entering a part position, you can test the waters and if the trade moves as you expect then you can add to the position. This is known as scaling in. Most traders enter a position in one full parcel and exit the same way. However another tool you could use is adding to a winning position, maximising the returns from a good trade. Starting with a position less than your maximum you can add to the position at preset intervals. Scaling in is one of the most under used techniques by traders. Spend as much time developing
    your position sizing model as you spend on looking for good entry techniques.

    Holding

    The world famous speculator from the early 1900’s, Jessie Livermore, made the following comment in “The Reminiscences of a Stock Operator” written by Edwin LeFevre:

    “And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!”

    Jessie Livermore commented that most money in the market is made from sitting, not thinking, referring to the fact that holding positions was a key to his success. It takes time for a trade to play out and having the patience to allow the trade to develop is critical to the success of the trade. This does not mean that a trade that does not work out should be held until it becomes profitable. A stop loss is an efficient way of dealing with these trades, but for profit to grow takes time.

    Scaling Out

    Scaling out of a position is the reverse of scaling in. You exit part of a position on the first signs that the market may be turning around, then exit more once the turnaround is confirmed. A common strategy employed is to exit 1/3 of a position when the trade has moved in your favour by the amount of your risk, 1/3 of the position to take a profit at twice your risk and the final 1/3 when the trend finally ends.

    Scaling out aligns your trading with the trend as it unfolds and increases the probability you will have a successful trade. As a trend develops it is inevitably getting closer and closer to the end of the trend. No trend goes on forever and there comes a time when the odds favour a reversal rather than a continuation of the current trend. It is impossible to consistently pick the top and bottom of a trend and scaling out allows you to capture the most likely part of the trend, but also hold onto gains until the trend ends to maximise your winners.

    Taking Profits

    When a trend finally ends it is time to take profits. Unfortunately a flag does not go up to signal the trend is over, so as a trader you are looking for clues that alert you to the end of a trend. As we mentioned in the section on holding, it is important to be able to distinguish between a pull back and a change in trend. There are a number of different techniques for taking profits and completely exiting a position. Choose the exits that you find appropriate to your particular style of trading, and you can always use more than one exit, taking the exit that works best for you. More than any other part of your trading, rules are required for exits.

    Any exit signal that you use should be based on set criteria. Once you are in the heat of a trade your perception of what is happening is altered. It is often linked to your profit and loss rather than to what the market is doing. You can become emotionally involved with the position and your decision-making criteria can become altered. Exit the trade when your signal occurs. If the trend continues and you are exited too soon you can always re-enter if the market conditions continue to be in your favour.

    Re-entry

    It can be frustrating to be exited from a trade too early, but exiting from a trade does not mean the opportunity no longer exists. If you are exited too early you can re-enter a trade provided the reasons you got into the trade remain valid.

    As part of your trading plan you can determine what has to happen for you to take a re-entry. It is possible to re-enter immediately after being stopped out, but this does come with some risk that the re-entry is too soon. If you have been exited from a long trade, it may be that the market bounces higher only to fall away soon after. A less risky approach is to watch the pull back to see whether the market is going to continue to drop or bounce higher. A re-entry can be taken once you confirm the market is moving higher.

    Remember your first entry may not be perfect, but if your reasons for entering the trade remain valid, then a re-entry can add to your success. If at first you do not succeed, try and try again, provided the criteria for the trade remain valid.

    Re-entry can be one of the hardest things to learn, because you have exited the trade to take profits, or cut a loss. You then have to adjust your view to confirm whether the original reasons for entering the trade remain valid and decide whether it is appropriate to get back in to the position. This requires you to be flexible and to remain emotionally detached from your trade.

    Conclusion

    Mastering these core skills will dramatically improve your trading results regardless of the market you are trading. Identify the area where you are weak and work to improve on that area. Master one skill at a time to improve your trading overall.

    By Jeff Cartridge
    Education Manager

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    Stocks for the Christmas Hamper

    Friday, December 16th, 2011

    Investors have generally had a tough year in 2011, so to finish up our Analyst’s Eye series for the year we thought it may be worth noting what stocks you could consider for 2012.

    At this stage the prospects for 2012 remain uncertain. We know that the eurozone will still be troubled by mounting sovereign debt and slowing global growth prospects.

    One way to trade into the New Year is to take a more domestic focus trading in stocks with consistent fundamentals that reward shareholders through a strong dividend stream.

    We have done a quick review using The Bourse software to search the S&P/ASX 200 for stocks that meet the above criteria and summarised them in the chart below. Note we sorted these stocks by year-to-date performance.

    Dividend Paying Stocks
    (Click to enlarge)

    There are a number of ways to utilise this information for your investing in 2012, including:

    • Choose the stocks that have performed the best in terms of YTD return and Yield, such as NIB Holdings, Telstra Corporation and Metcash. This method assumes that these stocks will continue to outperform into 2012.

    • Choose the stocks that offer the best in terms of Dividend Yield, such as NIB Holdings, Telstra Corporation, Tatts Group, Myer Holdings and David Jones and Perpetual.

    • Choose the stocks that have performed the best in terms of Return on Equity and Yield, such as Telstra Corporation, AMP, Myer Holdings, David Jones and Perpetual. Note this list includes a number of retailers which have the added risk that if the retail environment continues to deteriorate the size of the dividends may be reduced.

    • Choose stocks on a contrarian basis, that is those stocks that have been heavily sold off in the past year and trading on single digit PE, on the hope of a recovery into 2012, such as Westpac Bank, ANZ Bank, Myer Holdings and David Jones. Note this is a similar methodology to the “Dogs of the Dow” methodology used by traders in the United States, to select high yielding, underperforming stocks.

    So decide on your selection criteria and add some of these stocks to your Christmas hamper. Additionally keep a watchlist of these stocks, so that you can start accumulating if there is another sell-off in the first quarter of the New Year.

    While trading in high yielding stocks is not guaranteed to deliver strong returns to investors or traders, dividends do offer a margin of safety, which can in turn boost any capital return on the company’s shares. Dividends also offer Super Funds the additional benefit of franking credits which can boost the portfolio’s annual performance.

    Wishing you all a Merry Christmas from the Research Team, and we trust that Santa Claus delivers exactly what you want for Christmas. We will return in the New Year.

    Michael Hevern
    Investment Adviser

    For Buy and Sell recommendations on ASX listed companies register for a FREE trial of MDS Financial Research.

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    Ho, ho, ho. Tis the Season to Be Jolly!

    Friday, December 9th, 2011

    With Christmas fast approaching, the seasonal patterns in the stock market suggest that the markets are likely to be stronger into the end of the year. Historically it is normal for the stock market to rally in December. This rally is known as the Santa Claus rally and brings Christmas cheer to all investors.

    Seasonal patterns were first discussed by Larry Williams with reference to commodities. Larry noted that seasonal price fluctuations occurred in agricultural commodities with prices falling when there was an abundant supply around the harvest times and prices rising when supply was scarce, prior to the next harvest. These seasonal patterns can also be observed in the stock market as supply and demand for shares fluctuates throughout the year.

    The Australian market is typically strong through March and April, as it was this year, and then weaker through June, before rallying again in July. The July rally failed to eventuate in 2011, but the June weakness was certainly visible, so much so it carried on through July. October has a deservedly bad reputation for falling throughout the month and has become famous for the 1987 crash, the 1997 collapse of the Asian economies and the sharp falls during the credit crunch in 2008. A bottom is often formed in November and early December before a strong rally is seen in the final two weeks before the New Year.

    Christmas Rally

    The seasonal odds certainly favour a rally at this time of year. In Australia during the last 27 years the Santa Claus rally failed to materialise in just four years 1990, 1995 2007 and 2010. The average return over the last two weeks of December is 4.9%. If this rate of growth was to be sustained throughout the year we would see annual growth of 119% per annum in the markets. Why is it, that Christmas only comes once a year?

    While seasonal patterns are not guaranteed to deliver strong profits to investors or traders the patterns do have a high probability of playing out in the future. Not all the reasons for these seasonal tendencies are clear, but it can be very profitable to follow them through all the same. I wish you all a Merry Christmas and I trust that Santa Claus delivers you exactly what you want for Christmas. I will certainly be positioned to take advantage of his generosity.

    Jeff Cartridge
    Education Manager

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    Which Stocks are Potential Comeback Candidates?

    Friday, December 2nd, 2011

    The Australian market has pulled back since its spectacular run in October this year, when the ASX/S&P 200 climbed a staggering 15 percent. In light of this you may wish to find stocks that are likely to stage a comeback in the near term.

    In our recent article on identifying stocks with pullback potential we highlighted three candidates due for a pullback, and anyone who followed those ideas could have picked up between 5% and 12% on these trades over the past few weeks.

    Market Analyser Can Help

    You can use the Market Analyser software to identify keys stocks which are indicating they’re due for a comeback.

    Start by using the Watchlist Wizard tool to quickly create a watchlist of stocks from the ASX Top 300. (For help with this tool check this post.)

    We can then use the Prealerts scanner to identify stocks that indicate there is “accumulation” taking place, meaning the stock is being picked up by stronger hands as we run into the end of the year.

    A scan yesterday produced the following list:
    Accumulation scan in the Market Analyser

    As you can see there are a number of stocks that are currently undergoing accumulation and could offer a potential buy signals. You may want to research these companies further before entering a trade.

    The effectiveness of this scan depends on the current trend of the underlying stock and we have illustrated this in the following three candidates that came up in the scan in the past couple of days:

    1) ANZ Bank (ANZ)
    2) Wesfarmers (WES)
    3) S&P/ASX 200 Index (XJO)

    Note that you can also use volume as a confirmation for the buy signal, as you would be looking for volume to pick up as the prices rise.

    ANZ Bank (ANZ)

    ANZ is a major Australian-based bank operating retail and business banking franchises throughout Australia, New Zealand and the South Pacific. ANZ’s goal is to become Australasia’s leading, most respected and fastest growing major bank. Strategic expansion in Asia differentiates ANZ from its peers, and ANZ CEO Mike Smith has said that he expects 30 percent of its income to come from the Asia-Pacific unit by 2017.

    ANZ Bank Chart with Accumulation Indicator

    You can see that the Prealerts worked pretty well for ANZ earlier in the year. Even though the overall market was trending down, the Prealerts gave five successful signals that ANZ was due for a bounce. When the stock price was trading into a potential support zone the Prealerts offered a great signal of when the stock price was likely to bounce. ANZ has now surged 8 percent since the signal.

    Wesfarmers (WES)

    Wesfarmers Limited (WES) is a diversified business covering supermarkets, department stores, home improvement and office supplies, coal mining, insurance, chemicals, energy, fertilisers, industrial and safety products.

    Wesfarmers Chart with Accumulation Indicator

    Wesfarmers has been trading sideways for the past four months and the Prealerts indicator had given a good signal that the share price was due for a comeback. If you took this signal you would be up around 3.5% in two days and would be watching carefully for price action around the $31.30 level, which had been the key support level in the past month.

    S&P/ASX 200 Index (XJO)

    Since mid-November the S&P/ASX 200 Index had been sold-down heavily with the all negative sentiment over the eurozone debt crisis, but the index appeared to be due for a relief rally.

    S&P/ASX 200 Chart with Accumulation Indicator

    Again the Prealert scan has given some great signals in the past six months. There was another signal in the middle of last week which suggested a comeback was due and the index has since risen 5.5%. We would now be monitoring price action around the key pivot level of 4180.

    Summary

    Utilise the Prealerts features in Market Analyser to scan the markets for your specific trade selection criteria. You will save time and identify some likely comeback candidates.

    Disclaimer: The information provided within this article is not a recommendation to trade a specific stock, but is intended for educational purposes only.

    By Michael Hevern
    Investment Adviser

    For Buy and Sell recommendations on ASX listed companies register for a FREE trial of MDS Financial Research. Subscribers are in successful trades for ANZ, BHP, XJO, NAB and RIO to name a few of the recommendations over the past week.

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    Which Stocks Are Ready To Pull Back?

    Friday, November 18th, 2011

    The overall Australian market had a spectacular run in October this year, up a staggering 15 percent from trough to peak on the ASX/S&P 200. In light of this you may wish to ask the experts what stocks are likely to pull back in the new term.

    Market Analyser Can Help

    You can use the Market Analyser software to identify keys stocks which are indicating that they’re due for a pull back.

    Start by using the Watchlist Wizard tool to quickly create a watchlist of stocks from the ASX Top 300. (See below for instructions on using the Watchlist Wizard.)

    We can then use the Prealerts scanner available to Market Analyser users to identify stocks that indicate there is “distribution” taking place, as stock is offloaded into the weaker hands.

    Set up this scan through the Analyser Wizard, a handy tool within the Market Analyser allowing you to access the Prealerts indicators. For help with this tool check this post.

    Market Analyser: Selecting the Analyser Tool

    Yesterday’s scan produced the following list:

    Market Analyser: Distribution Scan

    As you can see there are a number of stocks that are currently undergoing distribution and could offer a potential sell signal. You may want to research these companies further before entering a trade.

    The effectiveness of this scan depends on the current trend of the underlying stock, and we have illustrated this in the following three candidates which came up in a recent scan:

    1) AWE Limited (AWE)
    2) Metcash (MTS)
    3) Spotless (SPT)

    Note that you can also use volume as a confirmation of the sell signal, as you would be looking for volume to pick up as the share price falls.

    AWE Limited (AWE)

    AWE (formerly Australian Worldwide Exploration Limited) is engaged in exploration, development and production of oil, gas and condensate primarily in Australia and New Zealand. AWE concentrates on exploration and appraisal-type assets, in regions of proven prospectivity and where there is a high chance of commercial success.

    Market Analyser Scan - AWE Limited

    You can see that the Prealerts worked fabulously for AWE earlier in the year, giving four winning sell signals when the general trend of the stock was down. Now that the stock price is attempting to recover, the Prealerts offer a good signal of when the stock price is likely to take a pause. AWE is now at a key resistance level, but you would want the stock price to trade below the previous swing to confirm a sell signal.

    Metcash (MTS)

    Metcash Limited (formerly Metcash Trading) is a wholesale distribution and marketing company specialising in grocery, fresh produce, liquor, hardware and other fast-moving consumer goods. MTS has four business units: IGA Distribution, Campbells Wholesale, Australian Liquor Marketers and Mitre 10.

    Market Analyser Scan - Metcash Limited

    Metcash has been trading sideways for the past couple of months and the Prealerts signal has given a great signal that the share prices was due for a pull back. If you took this signal you would be up 4.5% in two days and would be watching carefully for price action around the $4.10 level which has been the key support level for the past couple of months.

    Spotless Group (SPT)

    Spotless Group Limited is engaged in the provision and outsourcing of labour-based services in Australia, NZ and USA. Their Retailer Services division provides hanger systems, labels and packaging to the garment manufacturing and retail industries worldwide. Facility Services provides facilities management and support services like cleaning, food, linen and garment services in Australia and NZ.

    Market Analyser Scan - Spotless Group

    Again the Prealert scan gave a great signal back in mid-May. There was another signal in early October which pre-empted a sideways move for 3 weeks, but now we have a signal in as the share price finds resistance at multi-year highs, and offers a low risk sell signal. Note that Spotless Group has confirmed it has received a $698 million takeover proposal (at $2.63 per share) from buyout firm Pacific Equity Partners, but says its directors view the bid as too low. The bid from PEP comes six months after Spotless rejected a $657 million offer from US buyout giant Blackstone Group.

    Summary

    Utilise the Prealerts features in Market Analyser to scan the markets for your specific trade selection criteria. You will save time and identify some likely pullback candidates.

    By Michael Hevern
    Investment Adviser

    For Buy and Sell recommendations on ASX listed companies register for a FREE trial of MDS Financial Research.

    Instructions – Using the Watchlist Wizard

    1. In Market Analyser, open a watchlist window by selecting Menu > Watchlist
    2. Click on the Watchlists item on the top menu bar, and select Watchlist Wizard.
    3. In the Watchlist Wizard window click Next, select Australia from the Countries list, then select ASX Top 300 from the Available Watchlists list on the right of the window.
    4. Click the Update button. Your new ASX Top 300 watchlist will now be available from your watchlist window.

    Disclaimer: The information provided within this article is not an invitation to trade a specific stock, but is intended for educational purposes only.

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    How Understanding Volatility Can Improve Your Trading

    Friday, November 11th, 2011

    The markets have certainly been volatile lately. This is a comment that you may hear on a regular basis and it is often used to describe a share or market when it falls sharply, but what does it really mean? And more importantly, how can we use an understanding of volatility to improve our trading?

    Volatility is the fluctuation in share price as measured over a period of time. If one share moves in a range of 20 cents in a week and another share moves in a range of $1.00 in a week, this would be considered a more volatile share. Note that this says nothing about the direction of the movement, just the range of movement. This is one way to measure volatility and there are many other ways to measure it as well.

    The average true range (ATR) is a measure of how volatile a share is on a daily basis. The true range is the movement from the high of the day to the low of the day including any gaps that may occur. The average true range is the true range, averaged out over a number of time periods. In Computershare, shown in the chart below, the ATR(10) varies from a low of 10 cents to a high of more than 30 cents. A spike in the ATR has occurred recently following the announcement that Computershare has gained approval to take over a US based share registry. Looking closely at the chart you will see that when the volatility spikes it can be a sign that the share is about to reverse direction as it did in May and August this year, but the reversal was slower coming in January.

    Understanding Volatility

    Statistically speaking the range can be defined by the standard deviation, which is the range required to contain a certain percentage of price movement. 99% of price movement is contained within 2 standard deviations of the current price, so only in very rare cases will the price move beyond 2 standard deviations. Bollinger Bands display two bands that are 2 standard deviations from the current price as shown on the chart below. When the bands tighten up the volatility is low and when the bands widen out volatility has increased. As you can see in the chart below volatility has increased sharply following the announcement. From a trading perspective, when the share price breaks outside the band then expect a reversal as can be seen in August, September and October and again recently.

    Using Bollinger Bands when analysing volatility

    While these measures can easily be applied to an individual share there is a more sophisticated way to look at volatility which is more informative than a simple mathematical calculation. The volatility index, known more widely as the VIX, measures the premium that is being paid to purchase options on the S&P 500 index. To correctly price options it is necessary to take into account the volatility of the underlying market. If option prices spike then it is a sign of an increase in volatility in the market. In Market Analyser the volatility index is accessed by the code .VIX and the underlying index is the S&P 500 .INX. Both of these can be displayed on the same chart using the Overlay security function.

    The Volatility Index VIX

    The VIX is shown in pink on the chart overlayed on the S&P 500. Volatility has certainly been higher during the last 4 months than in the few months preceding it based on the VIX. Note the turning points in the index often coincide with the turning points in the VIX. Once the index reaches an extreme a reversal is imminent. High readings in the VIX correspond with points where the market turns higher and low readings in the VIX can signal sharp drops.

    Using these tools you can measure whether the market is volatile right now and also use this knowledge to assist in identifying turning points in the share or market you are following.

    By Jeff Cartridge
    Education Manager

    Test this strategy for yourself! Download a free trial of the Market Analyser software here.

    Computershare was recommended as a buy by MDS Research Team at the start of November. You too can get advantage of our buy and sell recommendations on ASX listed companies by registering for a free trial of MDS Financial Research.

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    Beware The Bull Trap

    Friday, November 4th, 2011

    The global markets have had a strong run since the late September, and we saw euphoric buying last week after the EU summit announcements that they will be delivering on their “comprehensive” bailout plan, with private investors taking a “voluntary” 50% write-down on sovereign Greek bonds, the size of the eurozone EFSF bailout fund will be increased to EUR1 trillion, and Greece will aim to reduce its debt to 120% of gross domestic product (GDP) by 2020.

    Traders have been pushing stock prices higher since the “comprehensive” bailout plan was first mentioned in late September. However we have seen a turn in the momentum for the ASX market near-term, and this has given rise to a potential bull trap being triggered.

    The S&P ASX 200 has risen over 15% from its recent low to high, but traders are starting to take profits and appear to be heading for the exits in the short term. Investors are showing some concern over the implementation strategy for the EU “comprehensive” bailout plan.

    In the case for the bulls the Central banks around in the eurozone have been taking measures to address the economic debt crisis and the US Fed Reserve announced “operation twist” and is rumoured to be considering QE3 for some time early next year.

    However up until this week, traders have chosen to ignore the rumblings over how difficult and protracted the solution for the eurozone debt crisis resolution will be, plus the implications of a slowing Chinese economy in relation to demand and commodity prices, and the corresponding impact on resource company earnings going forward.

    A number of markets globally have set up and/or triggered “bull traps” as they have recently backed off key resistance levels. Traders have been looking for an excuse to take profits, and the resurfacing of concerns over the implementation issues over the EU “comprehensive” bailout plan appears to be a catalyst at least in the short-term. Also there are concerns raised by the fallout over bankruptcy the of the world’s leading futures and derivatives broker, MF Global.

    Bull Traps

    A bull trap occurs when investors take on a long position when a stock is breaking out to new highs, only to have the stock reverse and shoot lower. This counter-move produces a trap for the bulls and often leads to sharp sell-offs.

    The criteria for a bull trap set-up:
    1. A prevailing long-term down
    2. A sharp correction that has moved quickly from its lows
    3. Resistance where investors look for price rejection setting up a long squeeze

    The Bull Trap Set-Up

    The bull trap set-up is fairly basic. Look for a trading range to be broken to the upside, preferably with high volume. The stock will need to get back below resistance within five trading periods, then explode out of the bottom of the range. The last component of the bull trap chart pattern is that the stock should have a wide price trading range. This increases the odds that the stock will have room to trend lower in order to book quick profits.

    The Market Psychology of Bull Traps

    Selling in the first wave will occur when the most recent swing low is exceeded. This occurs because of the number of shorter-term traders who have their stops slightly below the most recent swing low. The second wave of selling comes into play once the medium term traders realise that this is not just a slight retracement and the move is likely to be more protracted. This produces the second round of selling.

    Bull Traps Trading Examples

    There are a number of prime examples of recent bull traps, including the ASX, the S&P500 and the German DAX.


    Figure 1: Bull Trap – S&P/ASX 200 (XJO) November 2011

    Last week the S&P/ASX 200 broke to the upside to a 3-month high, after having risen over 18 percent in the past month. However the bears then stepped in sending the price through the test the lower band of the recent trading range within a few trading sessions, completing the bull trap. The volume did not provide confirmation for this trap but the selling continued with the stock dropping -8 percent in the following 3 sessions. If the market falls through the current support level, then a retest of the recent lows is possible, while a breakout above the recent highs will signal a resumption of the up-move.


    Figure 2: Bull Trap – S&P 500 (.SPX) November 2011

    The S&P 500 (.SPX) recently broke to the upside to a 3-month high last week, after having risen over 20 percent in the past month. The bears have stepped in sending the price through the recent uptrend within a few trading sessions. If the selling continues a bull trap will be confirmed. The stock has dropped over -5 percent in past couple sessions. If the sellers persist we would expect the US market to fall back into the 3-month trading range. If the market falls through the current support level then a retest of the recent lows is possible, while a breakout above the recent highs will signal a resumption of the up-move.


    Figure 3: Bull Trap – German DAX (.GDAXI) November 2011

    German DAX (.GDAXI) recently broke to the upside to close at a 3-month high last week, after having risen over 29 percent in the past month. Then we saw follow-through buying the next day as the bulls pushed the price higher. But then the bears stepped in, sending the price through the recent uptrend within a few trading sessions. If the selling continues a bull trap will be confirmed. The stock has dropped -10 percent in the past few sessions. If the sellers persist we would expect the market to fall back into the 3-month trading range. If the market falls through the current support level then a retest of the recent lows is possible, while a breakout above the recent highs will signal a resumption of the up-move.

    The Market Analyser software offers Pre-Alerts which are proprietary indicators that identify impulses in volume accompanied by a decline (D) in price. As shown in the accompanying charts these Pre-Alerts, used in conjunction with the standard Bollinger Bands, are very accurate for identifying bull traps.

    Conclusion

    Bull traps can develop in markets where there is panic buying or overconfidence, as the stock prices move into key resistance levels. The bulls are trapped because they are typically chasing the big moves in the market and are buying new highs as the price meets resistance. Once the market starts to fall, these new bulls try to extract themselves from the trap by selling. That selling pressure feeds back into the bear market and amplifies the subsequent move back to the downside.

    The question of course is whether a given reversal is really a bull trap or a legitimate reversal to the upside. The way to trade these set-ups is rather than attempting to pre-empt the market by shorting or covering immediately, you should typically wait for the market to begin rolling over to the downside.

    Use the Market Analyser’s proprietary Pre-Alert Distribution Indicator to identify when a setup is imminent (refer to the sample charts for examples).

    A change in market momentum and sentiment appear to be underway and bull traps are not just an opportunity for swing traders looking for a trigger to trade the short side of the market. They are useful for longer term traders as a signal to apply some risk coverage to their long positions, either through hedging their positions or stepping to the sidelines.

    Options are an ideal way to protect your position(s) and/or take advantage of the current market environment, because they allow you to trade with a defined risk. MDS Financial Advisory Services offers general advice on trading options to generate consistent steady income on your investment portfolio. Call 1300 610 024 and ask for me for further information.

    By Micheal Hevern
    Investment Adviser
    MDS Trading Desk

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    Options Trading for All Types of Market Environments – Part V: Dividend Capture Covered Call Collar

    Friday, October 21st, 2011

    The Dividend Capture Covered Call Collar, is the options trading strategy that traders can use to protect an existing position that has recently surged into a key resistance level and is about to pay a dividend. Rather than simply taking profits on the share position and potentially missing out on the dividend and future upside, the trader enters into a Dividend Capture Covered Call Collar. This options trading strategy seeks to protect your existing share position while still participating in some of the upside, including the dividend, for a modest outlay.

    The Dividend Capture Covered Call Collar allows you to participate is some of the future gains up to the sold strike price and hopefully the dividend, while being protected by the put position.

    Dividend Capture Covered Call Collar – is ideal for participating in future gains and picking up the dividend, while being protected on the downside.

    If you are of the opinion that the stock market is likely to sell-off and the share has little chance of breaking the key resistance level, but you still want to hold on to it for the dividend, you could use a Dividend Capture Covered Call Collar options strategy. The Dividend Capture Covered Call Collar strategy is similar to the protective put options strategy in that you also buy put options as protection. The difference is that you will now finance the purchase of those put options with the proceeds from writing an equal number of out of the money call options.

    The position will still protect you from losses below the strike price of the put options at minimal cost to yourself, but it will stop the position from profiting beyond the strike price of the short call options should the stock stage a rally and you could miss out on the dividend if this rally happens before the Ex-dividend date. That is you would miss out on a strong rally in exchange for putting on the protection of the put options for free (apart from commissions of course).

    Use a Dividend Capture Covered Call Collar when you expect the share price to move modestly higher or pullback significantly from current levels and you want to hang on for the dividend.

    Recent Trade – Westpac Bank for Dividend

    A recent trade we recommended was to buy Westpac above $19.37 on September 27. This trade was intended to capture to the dividend and the share price has subsequently jump to around $22.00 where it is meeting resistance. If you wanted to hold on to your trade for the dividend, (WBC goes Ex-div $0.74 on 8th November), then you could take advantage of this Dividend Capture collar strategy**.

    We entered the share position on the day of the recommendation at $19.67. The share price is now trading around $22.00 and has now been trading sideways for the past 2 weeks but it will go Ex-div $0.74 on 8th November.

    Given the turmoil in the eurozone which has been triggered by the problems with the European financial system and the debt crisis, we considered a Dividend Capture covered collar was appropriate for this position. Based on technical analysis you can see from the chart that the $22.50 resistance level has held for over six months.

    So we bought protection at $21.00 by buying 2100 DEC11 Put for $1.00 and then wrote the 2250 DEC11 Calls for $0.44. This trade cost 56 cents but we are protected until December expiry down to $21.00 and profits will be capped at $22.50.

    Chart 1: Westpac Dividend Capture Covered Call Collar Trade


    You can plan and analyse your trade as shown above, using the Derivative Profiler option in the Market Analyser software. MarketAnalyser also provides a payoff diagram for further trade analysis as follows:

    Chart 2: The payoff diagram for the Westpac Dividend Capture Covered Call Collar Trade.

    Trade Note

    Westpac (WBC) is still trading between the $21.00 and $22.50 option strike levels and only time will tell where the share price will end up at expiry, but we are protected until December expiry down to $21.00, but profits will be capped at $22.50**.

    The Trade

    Options can be used in order to reduce your risk while still participating in potential profits from a significant move by the underlying stock. We have explained the Dividend Capture Covered Call Collar strategy which is allows you to participate is some of the future gains up to the sold strike price and hopefully the dividend, while being protected by the put position.

    In future articles we will talk about the High Yield Covered Call strategy and the Covered Call Stock Reversal strategy which is particularly relevant to this market.

    Utilise the features in the Market Analyser software to trade plan your options trades for the particular options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk.

    By Michael Hevern
    Head of Research

    ** Please note your may need to refer to a tax profession regarding eligibility of franking credits.
    See Also:

    Options Trading for All Types of Market Environments (Part 1): The Protective Put

    Options Trading for All Types of Market Environments (Part 2): The Covered Call

    Options Trading for All Types of Market Environments (Part 3):The Covered Call Collar

    Options Trading for All Types of Market Environments (Part 4): Stock Repair

    For Buy and Sell recommendations on ASX listed companies register for a free trial of MDS Financial Research.

    MDS Financial Advisory Services offers general advice on trading options to generate consistent steady income on your investment portfolio. Call 1300 610 024 for further information.

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