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Fishing In The Right Pond

01/18/11 09:48:15 AM
by Billy Williams

Technical analysis is easy, provided that you're trading in the right market. But first, you must develop a low-risk idea to trade around.

Security:   TLT
Position:   Buy

The search for the next runaway move is often lost in the obsession of entry and the compulsive effort of implementing the perfect trading method, both of which often cause more lost opportunity combined with the after-effect of ill grace on the speculator's behalf. The explanation of why this occurs often ends up in a chicken-and-egg argument where one group of traders argues for the correct application of technical analysis, while the other side argues fundamental analysis as the underlying reason for taking the trade to begin with.

In a sense, both arguments are correct, but because they are out of syntax, they end up being a false positive and result in failure. No trend can escape the cause and effect of supply and demand. Yet, while they cannot avoid the underlying fundamentals that result in the trend to begin with, looking at the wrong investments when applying technical skills yields failure or, at best, mediocre returns.

How then can a speculator combine both fundamentals and technicals to create a viable trading method?

In order to trade a trend profitably, a speculator must first develop a low-risk idea. This typically involves a hypothesis based on certain data that reveals the likelihood that the fundamentals of a stock, industry, market, sector, or any derivative will be affected. It would be as if you were looking to catch a lot of fish, you must first find a good pond where there is a high likelihood of finding fish. In the markets, you must first form a low-risk idea that will lead you to a good spot to find opportunities.

Beginning this way makes applying technical analysis easy to apply as well as more profitable trades.

Currently, the US government is printing a lot of money, increasing its base currency level from $825 billion two years ago to $2.425 trillion now and increasing. Combined with the implementation of quantitative easing II by the Fed, this is creating a bubble in the bond market that is a low-risk idea to trade. (See Figure 1.)

FIGURE 1. The TLT has been making higher highs and higher lows lately, with a flag pattern revealing an easy entry into what could be a runaway move forming early in 2011.
Graphic provided by:
Now that a low-risk idea has been established, you must find a vehicle to analyze which, in this case, would be the ProShares Ultra Short 20-year Treasury exchange traded fund (ETF)(TLT). The TLT performs twice the inverse of the 20-year Treasury bond, which means that it has a 2-to-1 short position on the 20-year Treasury. For every point that drops on the 20-year Treasury bond, the TLT will rise twice that.

The bond market is under tremendous pressure right now as the Fed continues to print money in order to keep the US afloat, yet every type of bond in the country is weakening to the point of default by the issuer. The Chinese who own a large amount of US Treasuries are nervously watching and, if the US is not careful, there may be a stampede on a global level to sell off US Treasuries, creating a financial meltdown.

Even if the nightmare scenario above does not materialize, just the perception of a Treasury selloff could cause the TLT to explode in value.

Using simple technical analysis to begin trading this low-risk idea can lead to early entries with the potential for strong gains. If technical methods never materialize, then the idea simply won't pan out and you must look for fertile ground elsewhere. If it does pan out, then fails, continue to monitor the TLT or other low-risk ideas for another entry opportunity or until the fundamental picture changes or more attractive opportunities appear in another market.

Formulating your ideas and finding the right market to trade makes technical analysis far easier and your trades far more profitable.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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Date: 01/25/11Rank: 5Comment: 

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