Last week, we revealed how we've been using a proprietary trading system to "time" certain S&A recommendations... with terrific results. This system goes by the nickname "the Grail."
For example, Editor in Chief Brian Hunt used the Grail to time his recommendation of Denison Mines (DNN) back in October. The stock is up 134% since then.
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While "the Grail" has many uses, one of its most important features is its ability to pinpoint assets that have suffered a major fall, spent time digesting the move, and are now in a state of "compression."
"Compression" is a term used by traders to identify assets that have moved from a period of high volatility to a period of low volatility. Compression is what happens after an asset has fluctuated a great deal and has exhausted many market participants... who then reduce their trading activity. It's often the "calm before the storm" of the next major move.
For an example of compression, let's look at one of the top "table pounding" recommendations we received last year from the Grail's creator, Denny Lamson.
In late August, Denny noted how silver had enjoyed a big rebound in 2009 off its credit crisis lows. This big run was followed by a big correction in early 2010. Silver fell from $19 an ounce to $15 an ounce... and then began drifting sideways. During this sideways period, silver did less and less "wiggling." Silver's trading range became smaller and smaller. Denny compared silver to a coiled spring ready to release.
On August 25, silver exploded out of its compression stage and soared from $18 to over $24 in two months... a huge move in such a short time. The metal eventually ran to $30 per ounce.
Of course, the surge in silver was no surprise to us. We've been predicting surging gold and silver prices for a long time. What was impressive to us was the precise timing signal the Grail generated on an asset we felt was due for a run higher. Like pressure building under the earth prior to an earthquake, pressure was building in silver – and the Grail spotted it.
And this is no isolated event. The Grail is like a radar system traders can use to monitor the stock, bond, commodity, and currency markets to find unique compression situations. Marrying this "radar" with contrarian-focused fundamental analysis produces fantastic results.
So what's in "compression" right now? Where are the coiled springs? Denny and his business partner Ron say, "Check out solar stocks like symbol STP. Solar stocks aren't anything long-term investors should be concerned with, but the sector is capable of huge moves to both the upside and the downside. Right now, they are in compression, and poised to shoot to the upside."
Be sure to check your inbox for more information on the Grail... and keep an eye on solar stocks for a quick trade.
As I told you Monday, I'm out of the office, so I've put together some special material for this week's Digests.
We started the week with a piece from one of the best speculators we know. (If you missed it, go back and check it out here.) In today's and tomorrow's Digests, we're talking to one of the best traders we know, Jeff Clark.
I hardly have to detail Jeff's record of finding huge winners. One of his favorite strategies these days is to trade short on "busted momentum" stocks. Readers netted 77% in two months on the first busted momentum trade. The second was a two-week, 65% return. Jeff's last two busted momentum trades are still proving themselves out, but could make between 140% and 500%.
So I asked him to explain how these busted momentum trades work... and the best spots for trading today…
Sean Goldsmith: Jeff, over the years, you've traded "busted momentum" with a lot of success. Can you explain to readers how this works?
Jeff Clark: Sure. It's really not that complicated a strategy. Basically, a lot of momentum traders look at the 50-day moving average as an important pivot point on a stock. If a stock's trading above the 50-day moving average, it's in a bullish pattern, and momentum traders will be buying it. If it's trading below the 50-day moving average, the momentum traders look to sell it.
And so what I've done a lot of times with some success is, when a stock crosses back above or below its 50-day moving average, we use it as a key reversal point.
When you have a market that's been as overbought and as overextended as this one, short sellers – pardon the pun – take it in the shorts here. It's difficult to keep trying to time the top of the market.
So I look for stocks to roll over and actually break down below their 50-day moving average. And a lot of times, this happens in overvalued situations and overextended situations. So when it breaks the 50-day moving average, you have a shift in momentum. That happens quickly, and it's usually a fairly significant move to the downside.
As I caution repeatedly, as anxious as folks are to short stocks, you don't want to chase a stock lower. You want to sell a stock short when an oversold bounce occurs. So you watch for a stock to fall down below its 50-day moving average. Usually that's accompanied by high volume and a large move lower. Then you wait for an oversold bounce to come in and come back up and just basically "kiss" that moving average from below.
(Goldsmith comment: Here's what it looked like on one of Jeff's recent trades...)
And that sets up the ideal short sell opportunity, because at that point, you have a fairly low-risk entry point. The stock has had its oversold bounce, it's no longer beaten down into the ground, and if that 50-day moving average holds its resistance, the stock should turn around and start falling lower right away. If the stock can somehow manage to get back above the 50-day moving average, the whole pattern is moved, and we're off to the races once again… and you close out the short sell usually at a very small loss.
Now you have to have some flexibility with this, because in this day of high-frequency trading – where you've got computer algorithms and everything else running the market – folks who are programming know that we traders pay attention to this sort of thing… We've got to give it a little bit of room on the upside and the downside for the pattern to hold out. So it's not a hard stop at the 50-day moving average, but it's something you just sort of keep in the back of your mind. And like I said, it gives you a low-risk opportunity to jump in.
Sean Goldsmith: When you buy a put option for a bearish bet, how many months out do you typically go, and what strike price do you shoot for?
Jeff Clark: Well, it's tough to answer that because it depends on several factors… the price of the option obviously being one of them. Right now, we have a situation where it really doesn't cost that much to buy put options going out several months. So in this particular type of environment, I'm good with buying something three, four, even five months down the road.
Most of the time however, that's not a viable alternative, because the expense of the option increases just too much. Often I'll go with about a two-month timeframe.
And I like to trade options that are as close to "at the money" as possible. I'm not doing this yet, but I'll use Chipotle Mexican Grill as an example. The stock's trading around $260 a share. I would try to look for something around a $260 strike price. Again, price is a factor there.
Now the other thing that's important and I think has to be pointed out, what I like about using options instead of shorting the stock itself is, it's an automatic limitation of risk. Netflix is trading around $220 a share – to sell short 100 shares of that stock, that's a $22,000 trade. Whereas, I can go over to the option market and I can look at buying a put on it, and the put option itself would probably cost me around $1,500.
So rather than having a lot of capital at risk, we would have a minimal amount of capital at risk. If the stock continues its upward trajectory and just blows everybody out of the water, at least I know my risk is limited to $1,500.
And here's the key point with that. When you're using options, don't over-leverage the trade. Rather than putting $22,000 into the stock, you put $1,500 into the option. If you would normally short sell 100 shares of stock, buy one put option. If you normally short sell 500 shares of stock, then you'd buy five put options. You don't go nuts and buy 20 or 30 or 40 of them and overleverage the trade, because that eliminates the whole benefit of reducing your risk by using put options.
Sean Goldsmith: How has shorting changed since you started doing it 25 years ago?
Jeff Clark: Well, the auction market is much more efficient now. So rather than short selling stocks, we go to the option market. I rarely short sell a stock itself. I'll always go to the put options and use it that way.
Put options now trade in penny increments, so the spread between a "bid" and the "ask" is a whole lot tighter. Twenty-five years ago it was not uncommon to have a $0.30, $0.40, or $0.50 spread between the bid and the ask. And in some cases, that's a 10% difference on the option. That's a tough way to trade.
Now you've got penny increments, so it's much more efficient, much more price effective, and easier to do. Also, in the stock market itself, 25 years ago, you had a short sell uptick rule where you could only sell stocks short on an uptick. That prevented a lot of the strategies where you're looking to short a stock as the momentum shifts to the downside. You couldn't do that, because you had to wait for the stock to tick up.
So that doesn't exist anymore. If you wanted to do a pure play short on the stock itself, it's much easier to do that now. It's also a much more popular strategy. I think 2007 woke up a lot of people to the ability to profit as the stock market falls, so you have a lot more folks that are interested in doing that. And there's a little more competition out there to get shares to short, which again, is another reason to go into the option market, because you don't have to worry about trying to find a brokerage firm that can lend the shares to you.
Sean Goldsmith: Are there any sectors out there right now that folks should have their eye on shorting if the broad market enters a period of weakness?
Jeff Clark: The sectors that are most vulnerable to a pullback here are obviously the sectors that have been some of the best performers. Restaurant stocks come to mind. You can look at something like Chipotle Mexican Grill, which is straightening into a 52-week high, or Panera Bread… same story with that.
Not only are restaurant stocks trading at relatively high valuations, and not only are the charts extended, but they're also subject to rising input costs – that's inflation. And food costs have gone up considerably over the past few months and the restaurants aren't yet passing those rising prices on to consumers.
At some point, you're going to see a margin compression. You're going to see where the cost of the ingredients that go into the food or that go into the meals at the restaurants are more expensive than what's being charged itself. Margin compression is what we're looking for here.
And we're also looking for stocks that have a large amount of debt that's rolled over recently. Obviously, with interest rates on the rise, any company that's looking to issue new debt to replace old debt is going to suffer the disadvantage of that.
Tomorrow, we'll get into more detail on how Jeff plans to trade inflation and rising interest rates – along with a couple more sectors to watch over the next few months.
You can access all Jeff's research and his latest trade – a short bet on one of the highest-flying commodities – in The S&A Short Report. Click here for details.
Regards,
Sean Goldsmith
Miami, Florida
February 16, 2011How the Grail spots big winners early... What the Grail says now... The best trader we know on one of his most successful strategies...