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Opportunities In New Index Additions

12/19/11 11:14:55 AM
by Billy Williams

New stocks are deleted and added each week or month to the indexes, and knowing this fact can present a lot of opportunities for reliable trades.

Security:   PRGO, HMSY
Position:   Hold

Like clockwork, new issues are added and subtracted on the differing indexes. Where it can be sad to see stocks fall to the wayside, this is an inevitable part of trading and, more important, an essential part of the process to keep the economy going full-steam ahead as new products and services are brought to the market. These companies are hungry for investment and investors with capital to deploy are constantly looking for new and vibrant companies that seem to favor outsized gains over time.

This dynamic in the marketplace also creates an opportunity for smart traders who are always vigilant about finding new emerging opportunities.

As a company is removed from a particular index, it stands to reason that big institutional traders will redeploy their capital to compensate for a company's removal from the exchange -- in this case, by selling off its share and causing a decline in that stock's price. By the same token, the institution will seek to buy stock of the newly added stock to the given index in order to track the index's return. This is particularly relevant with respect to mutual funds that seek to match or slightly exceed the average annual return of a given index, the result of which is a quick gain in the stock's price as it moves higher on all the added buying from these funds.

For the skilled trader who is skilled in trading price with either the stock or options on the stock, the returns can be impressive while having a double bonus of being a consistent winner with relatively low risk.

FIGURE 1: PRGO. PRGO is a new addition to the S&P Midcap 400, which could mean a new move upward in time as mutual funds reallocate their positions to compensate for the newly added stock. Currently, weak market conditions have resulted in sluggish price action but could lead to a potential winning trade once the market turns.
Graphic provided by:
You see, these major players on Wall Street have to reposition their holdings based on what these indexes do in order to be compliant with their individual trading charters, which defines their trading strategy as well as their holdings. Knowing that they have to follow the guidelines mandated by their charters gives the market participant a strong edge by simply watching the news.

Recently, two companies -- Perrigo Co. (PRGO) (Figure 1) and HMS Holding (HMSY) (Figure 2) -- were reported to be included in the S&P Midcap 400, an index that tracks the largest 400 mid-sized publicly traded companies. By definition, the companies that make up the Midcap 400 have a market capitalization between $2 billion and $10 billion, which is calculated by multiplying the number of a company's shares outstanding by its stock price.

FIGURE 2: HMSY. On November 7, 2011, HMSY surged higher before it was announced that it was also to be added to the S&P Midcap 400. The stock has traveled too high to chase another entry, but if it consolidates in price and the general market turns higher, it could offer a second buy point.
Graphic provided by:
Through its subsidiaries, Perrigo develops, manufactures, and distributes over-the-counter (OTC) and generic prescription (Rx) pharmaceuticals, infant formulas, nutritional products, and active pharmaceutical ingredients (API) worldwide. When the announcement was made on December 9, 2011, that PRGO would be added to the Midcap 400, the stock formed a bullish dragonfly (a candlestick pattern where the open and close of the price bar is almost in the same price point in its upper level) but failed to go higher from that point in large part to the existing correction the market currently finds itself in.

HMS Holdings provides cost containment, coordination of benefits, and program integrity services to enable clients to recover amounts due from liable third parties, reduce fraud, and ensure regulatory compliance. It actually provided an entry position at the $27.82 buy point on November 07, 2011, as price moved higher on strong volume and price strength. It has moved too far since then to enter a new position, but if it begins to form another first stage base, then a new entry may make itself apparent once more.

In closing, any good fisherman will tell you that it isn't so much the fancy rod and reel that will catch a great fish as it is knowing which part of the lake has the best fishing spots where the fish congregate and it is very similar to the stock market. It isn't the fancy trading systems or computer graphics that allow you to catch a great trade, but knowing where the best stocks are and trading them accordingly. Just as it's smart to have a variety of methods to diversify your risk when trading, so too is having several methods for finding great stocks to trade and watching new stocks being added to indexes every few weeks or months.

Billy Williams

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

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