Wednesday, April 4, 2007

Spread Trading In A Choppy Market

This is a chart of the NYSE Composite Index. The top panel shows the adv/decl line moving average, the middle panel is the price, and the bottom is volume. The trend line marked "A" shows that the adv/decl moving average is not confirming the price move, "B". The downward sloping volume over the last two days should also give some caution to the idea of adding new long positions. This decreasing in volume is often the norm on holiday short week; the market will be closed Friday in observance of Good Friday.

This chart of the Nasdaq Composite is similar to that of the NYSE. When the adv/decl momentum lags the price of the market, it means that less and less stocks are carrying the load in the rally. The rally the past couple days because of oil taking a pause in its upwards move and the British hostages being released by Iran, is very suspect. Oil is still over $64 and tensions in the area regarding Iran still exist. That being said, with a holiday shortened week, it won't take much for the market to finish positive again today. It should be interesting to see if the market is up with an hour or so to go in the day, if it can hold the gains.

One strategy to use when the market is giving mixed signals is to look for spread trades. This is where you buy a stock you already like, and then look for a stock in the same sector, often a competitor, and take a short position in that stock. This, when done right, can help keep you in a winner in a choppy market.

This chart shows Juniper Networks and Cisco Systems. The top pane shows the spread(jnpr/csco)between the two stocks. When Juniper is outperforming CSCO, the blue spread line will slope upwards; the spread is increasing. To enter a trade like this, if you liked Juniper when it broke above the upper channel line, you would buy Juniper at that point and then short sell Cisco at the same time. You would stay in the trade as long as the spread was increasing in your favor. Increasing means that Juniper would be stronger than CSCO.

So the people at Cisco think JNPR is over priced? Well they can do the opposite trade. They might feel that JNPR should not be breaking out of that channel. So they would short JNPR and buy CSCO, with the intention that the spread would come back together, and that CSCO can not lag JNPR for long.

Another example is taken from a trade in 2005 between two coal companies, Arch Coal and Massey Energy.

In this trade MEE(Massey Energy) broke down out of a triangle pattern, and a short position was entered. There was a lot of talk at the time that Massey's coal had a high sulfur content and was not as desirable as some of the other sources. It was not an easy short idea on a fundamental basis because there was a big focus on the price of oil, and coal was still being talking about on a regular basis as an abundant alternative. Because of the risk of oil continuing to go up, shorting coal was not a risk free trade. To minimize this risk, a long position was entered in ACI(Arch Coal). This trade worked on both the long and the short side. This is not the usual case in a spread trade. The short trade on Massey energy was a +12pt winner, and the long trade on Arch Coal was a +7pt winner. In most cases the hedge side of the trade takes away from some of the profit.

An all time favorite spread to watch is between Goldman Sachs and Morgan Stanley. A short time after Goldman Sachs become public, there were stories that people at Goldman Sachs had shorted Morgan Stanley stock because the stock they owned in their own company was locked up; they could not sell for a certain period of time. Whether this story was true or not, it made for fun in watching the two stocks. With John Mack back at Morgan Stanley the stock has done well, but Goldman Sachs is still the leader. I still wonder if they short each other's stock. Maybe that explains why GS outperforms in the spread?

This chart is of the S&P 500 and the XLB(materials spdr). The top pane shows the spread between the two, along with a linear regression indicator of the spread. As long as this linear regression indicator is sloping upward, XLB is outperforming the S&P 500. This can be used to create a spread trade with either the tracking stocks of each index or through options. Spread trades can be expensive to carry, because there are two sides to each trade. It is not like owning one position, it requires more capital, so options can be an alternative at times.

When the XLB is outperforming, it is also a time to look into the material stocks to see which ones are leading that subindex. A few metal stocks did well on Wednesday.

Coal sector had a good volume day:

Some Triangle Patterns:

This looks like the stock that is carrying the heavy load in the DOW 30.

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