Thursday, January 13, 2011

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WOW - Woolworths continues to surf sideways...

  • Thursday, January 13, 2011
  • Chris Becker
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  • This will be a chart-heavy post, apologies in advance. I've kept the charts simple, and you may notice some indicators are turned off (upper left corner). I actually do this myself as I prefer to look at the price action as raw as possible and not get blinded by a mish mash of squiggly lines.

    Behaviour
    First, let's look at the medium term nature of WOW, using a 3 year period and weekly close on a line chart. I've added the 260 day exponential moving average (EMA). I find this is a better market indicator than the common 200 day average from my research on decades-plus time series of overall market moves.




    What is evident immediately is the downtrend since the GFC of late 2008/early 2009 and subsequently, the lack of a trend in the past year. Using the 260 EMA as a fundamental guide to wash out the intra-weekly trading noise, there has been a slight improvement in value since mid-2009, but overall price action is frustratingly sideways!

    Next, let's look in the relative short term at weekly and daily price data over the last 12-18 months:


    This chart is the daily close with a 15 day EMA. Price action is all over the place, with large reversals, head and shoulder patterns (a minor one in May to June 2009, a larger pattern in Sept to Nov 2010) and much randomness and noise.

    Note how on the medium trends (March-April 2010 and August-October 2010), price action seems to respect the 15EMA. A possible entry signal is generated when price closes above the 15EMA - this signal should be reinforced by performing such an entry at the lowest risk point - at the end of a correction! Further analysis shows that such a system, without causing whipsaw entries and exits, requires secondary confirmation.


    This chart shows the momentum oscillator I like to use to pick short term trends - the 2% signal line and momentum above its own smoothed average is the secondary confirmation I like to see for a short term uptrend, and above 5% for a medium term uptrend (or fast short term). The middle price movement broached 2% and gave a positive signal, although ultimately only small gains were made.

    Here's a closer look at the recent medium term uptrend from August to October 2010.



    Notice how most, if not all of the intra-day price action stays above the 15 EMA? I've included the Directional Movement System I use for trending price action. I use two signal lines that act as triggers for strong moves (the upper confirms a new trend, the lower the end of a trend)

    Notice how the initial short term trend starts with a close above the 15 EMA in early August confirmed by a crossover of the positive (blue) and negative (red) trend indicators. This then becomes a medium term trend price action confirmed as the positive DMI  crosses above the 30 signal line, and like how price action respects the 15 EMA, it stays above the 30 line for all of the medium trend.

    These are strong signals and help you ride a short and medium term trend (and know when to get off). But this has been the exception with WOW, with only 3 such trends in over 18 months, and the somewhat equivalent in corrections.

    So how do you trade what is predominantly a sideways stock?

    Sideways to Heaven
    I mostly trade sideways action, since the probability is more in my favour of a successful trade. Paradoxically, I make most of my money on the directional trades. This is the non-linear nature of trading full time!

    Trading sideways or directionless markets and stocks does require the use of different trading vehicles. The best, in my opinion, are Exchange Traded Options (ETO). If you are unfamiliar with options, Google it or go to Wikipedia or ASX Online Courses.

    My research and field testing (including one spectacular failure) has proved to me that selling naked options, in almost all circumstances, is not a long term profitable endeavour.

    A variation on the theme is selling option spreads, namely credit spreads. I use both Bull Put Spreads (selling a naked put but buying a lower strike put for protection) and Bear Call Spreads (selling naked calls but buying a higher strike call for protection). These vehicles have much less risk and capital requirements than covered call writing or naked selling. I know my maximum risk (loss) up front and can allocate my capital correctly.

    How does this work with something like WOW?

    Let's go back to the second chart, with a few modifications:


    I've used the 260 EMA again as an illustration of the general price move. The small orange lines represent possible 1 or 2 month to expiry credit spreads, whilst the darker longer lines are possible 3-6 month long credit spreads.

    How do I set up the shorter term spreads? Basically by looking for "End of Correction", "End of Trend" or "Short Term Uptrend" price actions. Notice how the "new" credit spread starts above a new high, or below a new low. I'm looking for these price actions because they provide the lowest risk trade.

    This brings me to Defensive Actions. What can happen after you set up say a Bull Put Spread, after the end of a correction?
    1. The price goes sideways for awhile, never really going down much more (a few % at most)
    2. The price goes up for a bit, but then runs out of puff after a few days of so-called "profit taking".
    3. The price goes up and starts a new trend.
    4. The price goes sideways, then a new wave of selling hits and the correction continues.
    Out of those 4 probable actions, which of the above are profitable when you sell a Bull Put Spread?

    Answer: the first 3. Why? Mainly because of time, or delta decay. I won't go into the "Greeks" of option trading, but the major one to be wary of is time decay. Here is the central concept of selling spreads:

    You are not trading direction, you are trading time.

    You are not looking for a directional target - you are looking for price to be above a certain point, for a certain length of time. Therefore, you need to trade with the balance of probabilities. Which is why I've gone the roundabout way of explaining Defensive Actions and why your entry point should be at or near "End of Correction", "End of Trend" or "Short Term Uptrend" price actions, not in-place directional trends (besides, option premiums tend to be very low in well-trending stocks).

    My Defensive Actions are simple:
    • If price goes sideways, I hold the position and wait as my position increases in profits
    • If price goes up a bit, then sideways, I hold the position and wait as my position increases in profits
    • If price goes up and starts a new trend, I'll usually add to the position (either the same position, or a higher strike, or a longer expiry or a combination thereof, and sell to close my original long option (to recover some premium)
    • If price goes down, I'll cover my sold option for a loss and hold my long option and consider a new trade (e.g selling a Bear Credit Spread above the recent price action)

    What timeframe?
    There are two considerations here, one is to get a regular income by selling credit spreads underneath the short term prevailing move. The other is to sell longer term spreads for less risk (and brokerage) but smaller annualised return on capital.

    The former strategy involves a lot of analysis and taking of risk, but in the end will almost always be more profitable than buy and hold (hope) or trying to trade the infrequent short and medium term trends. I need regular income so I use 1-2 month credit spreads as my main source of income. The longer dated spreads work well for adding income to your overall portfolio whilst waiting for capital gains.

    There is no reason to say you can't combine all three strategies. In fact, I do so in my Self Managed Super Fund (SMSF), using a cash-secured put twist. More on that one later....

    Conclusion
    I've shown a method of trading a sideways stock, through thorough analysis of short and medium term price analysis and using a different trading vehicle to the traditional long share.

    There are other strategies you can use. Strangles or Iron condors, or a calendar spread. I find credit spreads easier to understand and implement, as they keep me on my toes in readiness for the big earners - the directional trades.

    As for WOW, until we see a definite up-move in the 260 EMA, plus a secondary confirmation via quarterly change in momentum and direction, WOW remains in a solid "SIDEWAYS BULLISH" price action.

    This means for medium term traders and investors, the best trade is a 3-6 month dated Bull Put Spread (or a cash secured naked put for those of you wanting to acquire WOW). I would consider $26 to be the best upper strike (or naked level) for such a trade, as support here is very strong.

    Opportunities abound for sideways trading in this environment.




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