More Bang For Your Trading Buck

01/19/09 09:45:42 AM

by Alan R. Northam

One way to get the most bang for your trading buck is to short stocks from a market sector that is underperforming the market index to which it belongs.

Security: XLB
Position: N/A

The Standard & Poor's 500 has been divided into nine market sectors with the Basic Materials sector being one of those nine (see www.sectorspdr.com). Of those nine sectors, the Basic Material sector has been underperforming the S&P 500 itself. One way to get the most bang for your buck in a bear market is to short stocks from a market sector that is underperforming the stock market index to which it belongs.

Figure 1 shows the daily price chart of the Basic Material Sector (XLB). In November 2008, the Basic Material Sector entered into a corrective rally. Since that time, XLB traded upward, forming three short-term peaks and two troughs. I have drawn an upsloping trendline off the November low and the first trough in early December. As long as XLB continued to trade above this trendline, the uptrend remained intact. However, on December 22, XLB broke below and closed below this upsloping trendline. This officially ended the upward trend for the Basic Material sector. However, the breaking of a trendline does not indicate a reversal in trend, only that the trend is changing. The change could be a new, more shallow upward trend or even a horizontal trend, otherwise known as a trading range.

FIGURE 1: XLB, DAILY. This chart shows the upward sloping trendline, the 20-day simple moving average, and the 50-day simple moving average. This chart also shows that XLB has made a lower high price followed by a lower low price, which established XLB in a new downward trend.

Graphic provided by: StockCharts.com.

After a breakout from an upward trend, a reversal in trend occurs when three things happen. First of all, the market has to form a price minimum, known as a trough or valley. Second, the market must rally upward and make a lower price maximum, known as a peak. And third, the market must make a lower low price than the previous price minimum or trough. In Figure 1, XLB satisfied the first requirement when it made a price minimum in late December. XLB then satisfied the second requirement when it made a lower high (marked LH on the price chart) in early January 2009. Finally, XLB satisfied the third requirement when it made a new lower low in mid-January (marked LL on the price chart).

Unfortunately, once a new trend has been established, it is yet unknown if the new trend will last for only a few days or for several months. There are several ways to determinate if the newly established trend is short term or longer term in nature. One simple way to make this determination is to use moving averages. For this reason, I have added two moving averages to the price chart. I have added a 20-day simple moving average to determine the short-term trend and a 50-day simple moving average to determine the longer-term trend. As long as XLB continues to trade below the 20-day simple moving average and the 50-day simple moving average and these two moving averages continue to move lower, then the short-term and longer-term downward trend should remain in progress. However, if XLB starts to trade above the 20-day moving average and the 20-day moving average starts to turn upward, then that will signal that the short-term trend is ending. However, as long as XLB remains below the 50-day moving average, then the longer-term downward trend remains in progress. Once XLB moves above the 50-day moving average and the average itself starts to point upward, that will signal that the longer-term trend is ending.

In conclusion, it is a given that the Basic Material market sector has been underperforming the S&P 500 to which it belongs. This determination has been previously made using ratio analysis. This article has shown that the Basic Material market sector has completed a corrective rally from the late November 2008 low and has reversed its trend from up to down. Therefore, one way to get the most bang for your trading buck is to short stocks from this market sector.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.