Wednesday, March 14, 2007

Navigating Tough Waters

When the investing world's view starts to change from the glass is half full to the glass is half empty, it can be a volatile time, but one that also holds opportunity. It can be a stressful time, and this stress can cause a lot of people to make some irrational decisions. These irrational decisions are made on the basis of fear and the feeling that everything is different this time. Things are not different this time, its all part of human nature, and human nature keeps repeating itself time after time.

One thing that can be done when the market waters start to get choppy, is to limit the focus to a select group of stocks. This could be a sector or a list of stocks on a "wish list". It is very hard to watch too many things, so limiting the focus is key to avoiding careless mistakes. It is important to have this list before the market gets crazy. You can not wait until the market is down 250 points one day and then start deciding what you want to buy. It is important to do your homework.

When you feel the market has become oversold and it is time to buy, one way to start to test the waters is with exchange traded funds. There are ETF's that represent almost every index and major sub-sector in those indexes. As you start to test the waters in buying your decided upon ETF, you can also analyze the stocks in the ETF to see which ones are leading and which are load stones. It is best to buy leaders and not waste time with laggards. Buy the best stocks or ETF's when they are on sale, don't buy laggards or second bests just because you think they are safer. Go first class.

OIH is the Oil Service Holders group. It is made up of 15 companies and trades as a tracking stock under the symbol OIH. One method I have used is when the S&P 500 is weak, but I think is becoming oversold, and oil stocks have become oversold just because they are part of the index and not because of fundamental business reasons, I will look to buy call options. The call options I will look at will be a 30-60 days out, and I do look at strike prices one-two levels above where the market is trading. In buying options, you are limiting your risk to the money you have paid for the option, and you have some time on your side, usually 30-60 days.

Once the market has stabilized, and everyone realizes the world is not coming to an end, the call options should be in position to make money. This is the time to decide what stocks in the OIH you want to own. You can decide to own the index, and just stay with your position, or you can decide which 2 or 3 stocks are leading the index. As you buy these 2 or 3 stocks, you reduce your exposure by taking your profit in your call options.

One way to tell which stocks are strong within an index is by using spread charts. In this chart we have OIH at the top with NOV(National Oilwell) in the middle pane, and the spread between the two at the bottom. Since this spread(NOV/OIH) is positive, it shows that NOV has been stronger than the over all performance of the OIH. It is possible to have a chart with the spreads of all 15 stocks in the OIH. This makes it easy to view which are leading and which are lagging.

This can be done with the NDX(nasdaq 100), the S&P 500, or any other index. It is helpful to compare sub-sectors to the index too see if they are leading or lagging. If leading, it is then helpful to dig inside that leading group and find the true gems.

This is a weekly chart of the NDX(nasdaq 100)and Apple Computer; and the spread. This chart shows Apple has been a leader in the index.

If anyone would like a custom spread chart, leave a comment and I will see what I can do.

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