somewhere near the launch area. Of course, there were duds, crash landings and lost rockets on occasion.
So it is with the stock market. The market left the launch pad in mid December. Just like in model rocketry, we can estimate how high it will go by the size of the engine (volume, economic data, etc). What we can’t be sure of is how far the momentum will take the market after the fuel runs out. We also hope that the chute will open and it will return safely to earth. Barring any strange winds such as a blow up in Europe or war breaking out between Israel and Iran, we can estimate the recovery area.
We’ll plot the course on the weekly (DIA) chart which corresponds to the Dow Jones Industrial Average (NYSEArca:DIA).
First, let’s look at the Money Flow Index (green histogram). We can see that our propulsion maxed out in early January and is declining. It didn’t reach the levels of the 1st half of 2011 (our engine isn’t as big as QE2). Volume through January is below the moving average (blue line). The +/- Directional Indicator (2nd from the top) shows gravity is taking its effect on the DI+ although the DI- has not yet turned up confirming a trend reversal. The Relative Strength (at the top of the chart) is still trending up, but nearing its highs around 70. MACD and Stochastics are still trending up. The combination of these indicators tells us we are in the spent fuel, momentum phase of the trend.
On the price area of the chart, we see that we are at the resistance (bright green line) of our previous high of $128.37 or 12,837 on the DJIA. Momentum could carry it higher. Unless there’s a 2nd stage engine we’re not aware of (peace in the Middle East or resolve of Euro debt crisis), it’s unlikely to go much higher.
Should this trend roll over (which is likely), we can estimate the landing area. A “soft landing” (barring global calamities) would find support somewhere around $120-$122 or 12,000-12,200 on the DJIA. At this level we have the support of previous price (orange dashed line), 50 day moving average (pink line) and upper trend line (blue dashed line). Triple support should be pretty strong and likely to hold. A “crash landing” would find support around $106 or 10,600 on the DJIA. At this level we have price support (red line), lower trend line support (blue dashed line) and 200 day moving average (light blue line).
Now, with this information, what action should we take?
The first and most prudent action would be to take your profits off the table. There’s is nothing more agonizing than seeing your profits melt away. The next prudent action would be to set a stop loss slightly below the first support level—around $120 or 12,000 on the DJIA—this is the eject button prior to a crash landing. Taking these two actions are what I would consider “prudent” investing.
If you desire a more conservative approach, you could sell some of your investment (perhaps 1/3 to 1/2) along with the profits at this level. Should the market continue to rise, you’ll still get a piece of it. However, stops on remaining shares should be placed at first support.
A more aggressive style would be to place a trailing stop loss on the position. A hard day of selling would stop you out completely, but you would also be able to capture the full capacity should the market continue rising.
For the most active and sophisticated investor, you could enter an inverse ETF position such as the ProShares Ultra Short S&P500 (NYSEArca:SDS) or ProShares Ultra Short Dow 30 (NYSEArca:DXD) after getting stopped out of your long position and reap a profit or protect losses on the downside. Wisdom would be to wait a day to be sure the trend is reversing and not just a one day scare on a news headline. [Related: ProShares Ultra Dow30 (NYSEArca:DDM), ProShares Short Dow30 (NYSEArca:DOG)]
There is a plethora of choices for option traders. Some of the most basic would be to sell covered calls on existing positions (the most conservative option trade). You could also by puts against open positions to protect to the downside. If you sell shares and want to repurchase them at a lower level, selling puts is an excellent way to re-enter a position (although, you are making a future commitment by doing so). Of course there are put/call combinations too numerous to explain without writing a book.
Bottom line: Whether you are the most conservative style of investor or a sophisticated, active trader, taking profits at the current level and setting stops would be the minimum of prudent portfolio management.
Disclosure: At the time of writing, I currently have no positions in any of the ETFs in this article.
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