Understanding Price Action in Real Time
If you wanted to see a real time playbook of how the study of price action can help you sharpen your investment process, the last couple of weeks would be as good a place there is to start.
We have all been watching with various degrees of angst over all of 2015 how the SPX has gone painfully sideways for most of the year. Accompanied by the collapse of volatility, this has meant that the year has produced poor returns for those that trade the Indices. Conventional wisdom has made us believe that the best investment strategy has been to own the SPX on a passive basis and that over time, it will be hard for other strategies to beat this simple approach.
That is certainly a hard approach to fight against and for most people, it is the correct approach to simply BUY and HOLD the SPX. But if trading and investing is your profession, you simply cannot hide behind that passive approach. You have to do better. To earn your stripes, you have to dig harder. You have to get into the under-belly of the market. And you have to be able to read the dulcet tones and rings that the market sends your way on a consistent basis.
You need to create a process. A disciplined process that allows you to think and behave rationally in both volatile and quiet times. Let's try to understand this by using three real time examples.
The US indices have dropped sharply from the highs causing mayhem for a few days. This break has meant that the SPX is no longer in a sideways pattern. What took over 9 months to achieve to the upside was erased in less than a week. What are you to do now ? Do you get out on the rebound or do you hold on ?
The answer lies in what we call Relative Strength. Despite the big SPX drop, on a global basis the Index made new relative highs through the mayhem. The same was true of the NASDAQ. This is the market's way of saying that the SPX and NDX is not where the problems reside. We are not sellers of the U.S. Indices. They are longs in our portfolio.
For a professional trader, owning the US Indices has been the right trade. And for the discerning one, the correct trade has been to be short the Energy, Mining, Materials, Transports and certain semiconductor stocks. In fact throughout 2015, a long / short investment strategy using the Indices as your longs and these other sectors as your shorts would have produced spectacular returns. And beaten a BUY and HOLD strategy by a huge margin.
Relative strength is a phenomenal concept and one that you can employ as an anchor to your portfolio construction in all market conditions.
Let's discuss the example of Micron next. A stock that has been a hedge fund hotel stock for a while. You only need to go to the many outstanding blogs that are on the Internet to find out that Micron is indeed an interesting company to consider as an investment. After all, some very clever people have publicly stated their ownership of it. Now you can either follow these gurus and buy the stock or do some of your own work. And this is where Micron has failed miserably for us. It broke its Relative Strength pattern against the SPX over 5 months ago. And once it broke, it never recovered. It is still languishing. Professional money managers who have held the stock through this 50% crunching decline just needed to study price action to know that something was wrong with the stock. In fact, the discerning investor would have made a killing by shorting it on the Relative strength break. Many times, there is nothing wrong with a company but a lot wrong with the stock price. You need to see that signal clearly before it gets really costly. And act upon it.
And finally the Chinese stock market. There is now a real risk that China goes through a cathartic meltdown. It has lost its Relative strength on a global basis. So whilst the US Indices are clear longs to us, the way to ride out the volatility would be to have some shorts in China. Perhaps the Chinese banks serve as the best source of global Alpha on the short side. They have very poor Relative strength.
A lot of the techniques that help us to serve our institutional hedge fund client base are described in the course. You don't need to be lost in the current global mayhem. All you need is a robust process and the tutorial should give you a solid foundation to build on.