Newsletter

February 3, 2007

Taking on Greater Levels of Risk

Market & Sector Review
Warning Signs?

Largest Changes In Raw Numbers (21 Days)

This Week's Economic Reports

Taking on Greater Levels of Risk

Education never stops. No matter how long you've been a trader you know and understand that your education is a never ending process. You purchase and read books, newspapers and magazines, to continue your learning and to continue to prosper. While continuing our education you come across books and articles about some of the elite and brilliant traders who have a rare talent for making huge profits in a field where few can excel. "Market Wizards" is how we refer to them and being human we can't help but dream of being just like them.

Unfortunately, the facts tell us very few traders reach the top. The best most can do is evaluate and accept their abilities, and do their best. Pushing yourself too far and too fast doesn't work. It leads to frustration, and possibly failure. You must work at your own pace. This is especially true when one is attempting to take on greater levels of risk. Depending on your risk tolerance, taking on greater levels of risk can make you feel uneasy. If you want to make huge profits as a trader, you eventually need to learn to effortlessly take on greater levels or risk.

Extending ones comfort zone is never easy. For most people, it is a gradual process. For example, first one must learn to put their hard-earned money on the line, and accept what it feels like to lose it. Taking a loss is disconcerting and a little frightening. Losing a few dollars is one thing, but as the amount increases substantially, so does the pressure. It takes a little practice to learn to risk ever-increasing amounts of money and take it in stride. Some people are natural born risk takers. Most traders however have come to their present state; by learning to manage money wisely. The idea of taking larger and larger risks to move beyond your comfort zone can be difficult. You may have a natural inclination to protect what you've worked so hard to accumulate. It's tough to not be a little wary.

How do you learn to take on more risk? Again, it depends on your personality and the amount of trading capital in your account. You may need to train yourself to take on greater levels of risk. Move up gradually; don't make the mistake of moving too fast.

Taking on greater and greater amounts of risk is fear-provoking. If you do it all at once, you move from relatively little fear and anxiety to terrifying amounts of fear and anxiety. To shocking for many. It's better to work up to it. You wouldn't try to run a 10-mile marathon tomorrow if you could barely run a mile today. You would build up your stamina and gradually work up to your objective. It's the same thing with trading. Increase the amount you risk gradually. The rate at which you increase it depends on your personality. Use your own judgment; if you can increase your risk a little each trade, good then try to keep up that pace. If you find that after a month, you've surpassed your comfort zone, well then reduce your risk. The key is to gradually increase your comfort zone, don't force yourself to go beyond your limits. Work at your own pace. If you try to do too much, too soon, you'll just feel overwhelmed and you may never reach your objective. If however you move up gradually, you will increase the likelihood that you will be able to increase the amount of risk you can handle.

Trading is emotional. Taking on greater and greater amounts of risk is stressful. Instead of becoming overwhelmed, and possibly under mining your long-term financial goals, take it easy, and work at your own pace. You'll eventually be able to take on greater levels of risk, and trade more calmly, logically, and profitably.
Market & Sector Review
Warning Signs?

My research for the week ahead begins over the weekend. First I pick up the weekend edition of IBD, Barrons, and the Wall Street Journal (I still prefer to read the actual newspapers as opposed to all internet browsing). Anything that strikes me, good or bad, I then jot down in my journal. The first and perhaps most important note this past weekend was the distribution days IBD has recorded as of 1/26, four on the NASDAQ composite and three on the S&P 500 (As of Wednesday 1/31 two distribution days have dropped off on the NASDAQ, leaving two). While not a sell signal certainly a potential warning we could be getting close to one. The chart postings on site of these indices show potential distribution days. They are subjective. I simply use the formula supplied by one of Bill O'Neals books.

Now it's time to move on to the two new areas of the Prudent Trader site, Sector and ETF Analysis and see what we find. Since I am a big fan of relative strength I first sort both reports on the daily relative strength direction or trend. This is nothing more than a 21 day (approximately one month's worth of trading) linear regression line plotted on the relative strength, a short term indicator. Here is how it looks on a chart:

Looking first at the Sector Analysis page and sorting on the column heading "Daily RS Dir", I do a simple count, twenty sectors (64.5%) are still in up-trends, while five (16%) are in down-trends. Interestingly the five are: Banking; Electronics; Insurance; Energy; and Utilities. Nothing earth shattering here, just sector rotation.

Moving on to the ETF Analysis area, pulling up ALL ETFs, and sorting on "Daily RS Trend", I get a bit of a different picture. Of 316 ETF's only six (1.9%) by this measurement are in up-trends: BBH; RWR; SLV; ICF; VNQ; & IYR. A smaller amount, four (1.2%) are in down-trends: UTH; FXI; OIH, USO. Two energy ETF's and one Utility ETF confirming the Sector Analysis above. Now here is something interesting FXI (iShares FTSE/Xinhua China) is also ranked number one and number three respectively on the twelve month and six month relative strength rankings.

Are we receiving advance notice that the China play may be nearing its short term end? If I haven't convinced you before of the advantages, here is a great reason to take notes: because of the note on China I am very cognizant of the relative action of FXI from my weekend research. Monday looking over Charles Kirk's site, the following pops off the page: Jim Rogers thinks China is overvalued . If you're not familiar with Jim Rogers, get familiar, perhaps read one of his books.

At the moment what does all this tell me? Very simply: the market, or at least the ETF's, are waiting for something to give it direction. Flat directions will eventually resolve themselves however as of this writing it could be either way. In fact after the Fed statement on Wednesday, which shot the market higher by 100 Dow points, I kind of expected a change here, however as of Wednesday evening we show five in up trends and only two down. More flat than before. I am not bearish here and this is not a bearish newsletter, but I seem to be coming up with more questions than answers.

What could be the catalyst this market is watching? Everyone appears to be focused on every wiggle in the energy market and Tuesday saw a major advance (5%) in the price of Oil, a mammoth one day move. If everyone is focused on one area, the catalyst if there is one, is probably somewhere else. This is nothing more, than a contrarian thinking out loud. Take a moment and re-read the last three paragraphs do they suggest a possible catalyst to you?

Outside of the energy complex the weakness appears to be interest sensitive issues, i.e. banking, utilities, and insurance. Perhaps the markets are looking more at potential rate increases, not decreases. That's one possible catalyst.

Interest rates have been rising since December but still remain very low on a historical basis, the yield curve still remains negative. I'm not forecasting further rate increases, just pointing to the possibility. I hear no-one talking about that possibility, only rate cuts later this year. Looking over some more charts for possible negative catalysts, I find two of particular interest, that could become market catalysts in the future.

From the strength displayed above by iShares Silver Trust ETF (SLV) I was drawn to the Gold market (a more fluid market in my humble opinion). You can't help but notice the possible inverted head and shoulders formation. I think if gold can break above the yellow shaded area, on a volume surge, the bull will have resumed and pull backs should be purchased. The volume surge is an important consideration for this formation. If the volume is light on any breakout I would expect the breakout to fail. Check through the sector analysis area and find gold and silver stocks if that is your preference. Put a few in a watch list, just in case.

Gold, back 30 or so years ago was considered an inflation hedge. In this millennium it has been considered a currency, i.e. trading opposite the dollar. This is what led me to the dollar index chart. The dollar has been challenging a down trend line in existence since the end of 2005. Could it be the dollar and gold will decouple here, both going higher? If interest rates do indeed continue to rise and inflation becomes more of a concern the dollar will rise but in all probability so will gold.

Watch the gold, silver and dollar market's closely as they will move probably a good deal before the media begins to pick up on what is happening. Could this lead to the end of this bull market? Eventually I suspect however at this point I don't believe so. A correction could happen at any point for sure, however this market is just too strong. Equity markets have a tendency to make V bottoms they usually however, make rounded tops and at this point there are just too many bears looking to catch that top.
Largest Changes In Raw Numbers (21 Days)

This Week's Economic Reports

Have A Great Week!

Bill

Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.