The Stock Exchange is all about trading. Each week we do the following:
- Discuss an important issue for traders;
- highlight several technical trading methods, including current ideas;
- feature advice from top traders and writers; and,
- provide a few (minority) reactions from fundamental analysts.
We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some ideas, please join in!
Review:
Our previous Stock Exchange asked the question: “Were You Stopped Out?” We reviewed the dangers of using stop orders to limit risks, and discussed ideas for minimizing the chances of getting stopped out near the bottom only to miss out on the subsequent rebound. If you missed it, a glance at your news feed will show that the key points remain relevant.
This Week: Are You Out of Your Comfort Zone?
Traders often get comfortable with “what works,” until all of a sudden it doesn’t work anymore. For example, by historical standards, anticipated market volatility isn’t very high right now, but it is still twice as high as it was just last month, as measured by the VIX.
If you don’t know, the VIX is a market volatility measure, often referred to as the market “fear gauge,” and we just did a write-up about it earlier this week: What Investors Should Know About VIX. However, even though “fear” (anticipated volatility) isn’t exorbitantly high by historical market standards, the recent increase has taken investors outside of their comfort zone. Specifically, they got comfortable trading in a certain market environment (i.e. extremely low volatility) and now that that has changed, some traders have been taken way outside of their comfort zone. In the words of famous baseball player Yogi Berra: “The future ain’t what it used to be.”
This is relevant because there are a few important lessons to be learned (or at least reminded of) about how/when traders can/should stick to their setups and plans. For example, Dr. Brett Steenbarger has a brilliant write-up titled “A Powerful Technique for Changing Your Trading Psychology” which delves into the psychological problem of learning something so well that it becomes automatic. The problem is that when your environment changes, the conditioned behaviors you’ve developed become irrelevant and often even harmful.
Returning to our discussion of the VIX, many traders had become comfortable shorting volatility. And that trade was working great until volatility increased. For example, here is a look at what happened to the inverse VIX (XIV) security earlier this month when volatility finally increased:
A trade that had been working very well for many months, all-of-a-sudden turned into an enormous loss. And our suspicion is that the recent spat of increased volatility caught many traders off guard. Whether they were over-leveraged, or just too comfortable with risk, the market changed and they were not ready. And now they are outside their comfort zone in the new environment. According to Dr. Steenbarger:
Visualizing old ways of thinking, feeling, and acting that now bring us pain and allowing ourselves to fully feel all the disgust, guilt, remorse, and anger associated with the consequences of those patterns completely changes our trading psychology. We no longer fall into comfortable habits, because we no longer feel comfortable with those habits. We have turned them into enemies. That is powerful.
Source: Brett Steenbarger’s Trading Psychology Resource Center
Knowing how to adjust for different trading environments is important to us. And one way we’ve built this into our trading programs is to adjust our defined trading rules and systems based on market volatility levels. This allows the humans to stay out of the way while the trading models do what they are supposed to do in different market environments. Our human execution of the models trades provides an additional check that nothing is wrong, but we rarely make changes.
The key takeaway is that when the market takes you outside of your comfort zone, you need to adapt. In this case, when volatility levels change, traders should recognize their once profitable trading programs can quickly turn very destructive. And without adapting (in this case, our models adjust based on volatility levels), your profits can quickly disappear.
Model Performance:
Per reader feedback, we’re continuing to share the performance of our trading models, and the following table shows this week’s update.
Important to note, we find that blending a trend-following / momentum model (Athena) with a mean reversion / dip-buying model (Holmes) provides two strategies, effective in their own right, that are not correlated with each other or with the overall market. By combining the two, we can get more diversity, lower risk, and a smoother string of returns.
And for these reasons, I am changing the “Trade with Jeff” offer at Seeking Alpha to include a 50-50 split between Holmes and Athena. Current participants have already agreed to this. Since our costs on Athena are lower, we have also lowered the fees for the combination.
If you have been thinking about giving it a try, click through at the bottom of this post for more information. Also, readers are invited to write to main at newarc dot com for our free, brief description of how we created the Stock Exchange models.
Expert Picks From The Models:
This week’s Stock Exchange is being edited by Blue Harbinger.
Holmes: This week I bought Arista Networks (NYSE:ANET). Are you familiar with this one?
Blue Harbinger: Yes, Holmes—I am familiar. Arista supplies cloud networking solutions. Why do you like this stock?
Holmes: “Cloud networking solutions?” Can you be a little more specific, Blue Harbinger? And I like it for the same reason that I like all of my picks: I am a “dip-buyer,” and ANET’s dip over the last week is the sort of set up I like to see. From the chart below, you can see it is below its 50-day moving average, and it has attractive upside over the next six weeks.
BH: Interesting, Holmes. And yes I can provide a more specific definition of Arista’s business even though I know you are a technical model, and you’re far more interested in the price action and market conditions than you are in the fundamentals. Nonetheless, Arista pioneers and delivers software-driven cloud networking solutions for large data center storage and computing environments. Revenue and Net Income has been growing rapidly for this company over the last few years, but its price-to-earnings ratio is still fairly high, even after the shares fell last week despite announcing expectation beating revenues and earnings. Here is a look at the Fast Graph:
Holmes: So you’re telling me this company is basically growing like wildfire, it has essentially zero long-term debt, and it just announced expectation-beating earnings, but the shares still just sold off? I like Arista even more now than I did before.
BH: Well, if you must know, Holmes, the reason the shares sold off is because management says growth is slowing. After delivering 50% growth in the last two quarters, Arista’s revenues are only expected to grow by 37% this quarter.
Holmes: “Only” 37%? I still like this setup a lot. I usually hold for about six weeks, so check back with me then.
BH: Great. Thanks, Holmes. How about your, Road Runner—what have you got for us this week?
Road Runner: I sold my Whiting Petroleum (NYSE:WLL) stock on Wednesday 2/22 after purchasing it on 1/24. Here is a look at my “buy” chart followed by my “sell” chart.
BH: I see why you bought this stock, Road Runner. I know you like to buy stocks in the lower end of a rising channel, and you typically like to sell them after about four weeks, but this one did not work out perfectly.
RR: I ended up exiting at a lower price than I bought, but I was able to take advantage of a slightly higher price in a period of decline. You can’t win them all, but as long as the size of your winners is bigger than the size of your losers, you’ll do alright. We’ve written about this is previous Stock Exchanges, such as this one: Know When To Fold ‘Em.
BH: So what you’re saying is the price moved outside of your “comfort zone?” From a fundamentals standpoint, Whiting announced expectation-beating earnings and revenue, as well as forecasting a smaller than previously expected quarterly loss. This is an energy exploration and production company focused primarily in the Rocky Mountain region. And the recent unexpected drop in crude oil inventories will help the business. Here is a look at the Fast Graph, and as you can see Whiting has been struggling since energy prices plummeted in the second half of 2014.
RR: I wasn’t out of my comfort zone. I am an objective technical model, and I was created to specifically avoid the “comfort zone” issue you’re describing. However, thanks for that information. How about you, Athena—what have you got this week?
Athena: I like Twitter (NYSE:TWTR).
BH: What do you like about Twitter, Athena?
Athena: I am a momentum trader. Here is a look at the chart.
BH: You certainly are a momentum trader. It takes courage to buy a stock that’s just rallied nearly 38% in the last month. You must like that Twitter beat earnings and revenue estimates on February 8th when it announced, correct?
Athena: I like the things you mentioned, but my pick is based more on strong technicals.
BH: Well it’s nice to see Twitter finally turning a GAAP profit for the first time. However, I don’t think this company is growing fast enough to get excited about. According to the earnings release, fourth quarter revenue grew by only 2% year-over-year, and net margins are only 12%. Plus, it makes me a little uncomfortable that CEO Jack Dorsey is also the CEO of Square (NYSE:SQ). I question his focus. And honestly, I like Square’s business and growth potential much more. Here is a look at the Fast Graph for Twitter.
Athena: Thanks for the information, but you seem focused on long-term growth. My typical holding period is only about 17-weeks.
BH: Well then I’ll check back with you on Twitter in about 17-weeks. How about you, Felix—what have you got this week?
Felix: This week I like First Solar (NASDAQ:FSLR).
BH: You like First Solar?—this company designs, manufactures and sells photovoltaic (“PV”) solar modules with a thin-film semiconductor technology. First Solar has developed, constructed and currently operates many of the world’s largest grid-connected PV power plants. Any particular reason you like this company, Felix?
Felix: I am a momentum trader, but unlike the other traders, I hold my position for a longer time period, 66-weeks on average.
BH: Then I am assuming you are aware of more of the fundamentals, beyond only the technicals. How do you feel about the 30% tariff that was recently imposed on international (mainly China) suppliers of solar panels to the US.
Felix: The tariff may help First Solar in the near-term, although in the longer-term tariffs usually result in less efficient trade.
BH: First Solar announced earnings this week. They beat consensus estimates by $0.06 per share, although the company missed on revenue. And worth mentioning, First Solar has a strong balance sheet which will enable it to invest in its business going forward.
Felix: Thanks for that information, but I mainly like this stock because it has momentum and more room to run.
Conclusion:
When market conditions change, it often quickly takes traders outside of their comfort zones. And rather than sticking to a trading regime that was designed specifically for a market environment that no longer exists, it’s important for traders to “unlearn” old trading behaviors that used to create profits but now create losses. For example, our technical trading models make adjustments when expected volatility changes.
As famous baseball player Yogi Berra once said, “the future ain’t what it used to be.” In this case, the key takeaway is that when the market changes and takes you outside of your comfort zone, you need to adapt.
Background On The Stock Exchange:
Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check out Background on the Stock Exchange for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present and the only one using any fundamental analysis.
The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.
Stock Exchange Character Guide:
Getting Updates:
Readers are welcome to suggest individual stocks and/or ETFs to be added to our model lists. We keep a running list of all securities our readers recommend, and we share the results within this weekly “Stock Exchange” series when feasible. Send your ideas to “etf at newarc dot com.” Also, we will share additional information about the models, including test data, with those interested in investing. Suggestions and comments about this weekly “Stock Exchange” report are welcome.