Scott Pluschau: So far in 2011 there has been some interesting repeating phenomena in the Daily iShares Russell 2000 Index ETF (NYSE:IWM). The 50 day Simple Moving Average has been tested and held multiple times where I have drawn ovals on the attached chart. The “SMA” is explained at Investopedia.com as follows:
A moving average that is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react. In other words, this is the average stock price over a certain period of time. Short-term averages (e.g. 15-period SMA) act as levels of support when the price experiences a pullback. Support levels become stronger and more significant as the number of time periods used in the calculations increases.
Also very noticeable on the chart is on the upper graph, the Relative Strength Indicator, has been showing support in the 40-50 area, which is typical of a bull market. That has been another consistent low risk entry signal to get involved to the long side of IWM so far this year.
The Relative Strength indicator is explained at Investopedia.com as follows:
A technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued. A trader using RSI should be aware that large surges and drops in the price of an asset will affect the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to other stock-picking tools.
I feel there are two possible scenarios that need to be watched very closely in the near future.
One, only once has the 50 day SMA failed to hold this year, and it was retaken with a vengeance. A bounce off here has been a consistent low risk entry to the long side, with a tight stop below the 50 day SMA and targeting a new 52 week high, has paid handsomely.
Two, should the 50 day SMA fail to hold here, we need to watch and see if IWM is then rejected on the next attempt to retake the 50 SMA or not?
This is looking ahead, not making predictions, but merely preparing myself to react accordingly. I think this second scenario will have bearish implications. In that scenario of the 50 SMA failing to hold I would also like to see the RSI break the 40 level as further confirmation that a change in the intermediate trend may be at hand. Rallies back to the 50-60 level in the RSI along with rallies to the 50 SMA that get rejected “may” then become low risk entries to the short side.
As for scenario one, a bounce off the 50 day SMA, and the 40-50 level in the RSI holding, I would seriously consider getting long IWM if it were not for three things:
One, there is strong bearish negative divergence in the MACD that I have noted on the chart, as well as a crossover. The MACD is explained at Investopedia.com as follows:
A trend-following momentum indicator that shows the relationship between two moving averages of prices.
There are three common methods used to interpret the MACD:
1. Crossovers – As shown in the chart above, when the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell. Conversely, when the MACD rises above the signal line, the indicator gives a bullish signal, which suggests that the price of the asset is likely to experience upward momentum. Many traders wait for a confirmed cross above the signal line before entering into a position to avoid getting getting “faked out” or entering into a position too early, as shown by the first arrow.
2. Divergence – When the security price diverges from the MACD. It signals the end of the current trend.
3. Dramatic rise – When the MACD rises dramatically – that is, the shorter moving average pulls away from the longer-term moving average – it is a signal that the security is overbought and will soon return to normal levels.
Traders also watch for a move above or below the zero line because this signals the position of the short-term average relative to the long-term average. When the MACD is above zero, the short-term average is above the long-term average, which signals upward momentum. The opposite is true when the MACD is below zero.
Two, and much more important to me is the fact that the volume on IWM has been in my opinion abysmal on each breakout to new 52 week highs this year. I would never trust a breakout to new highs that is not accompanied by a significant increase in volume.
And finally third, the above average volume for the most part has been on selling, a major red flag of distribution.
In full disclosure it is for these last three reasons that I have been short the small caps via put options. I like to use options for speculation, because of the ability to define my risk. There is no need for a stop loss with “my” position; my initial premium has been pre determined as my stop, and that is the maximum loss on the trade. An adverse price movement via a large gap cannot increase the risk on my trade.
Also, there may be times when you are stopped out on a trade with an outright open position, only to see the price eventually rally to your target. The key words here in my strategy are “Money Management” and “Position Sizing”, and I cannot emphasize that enough. The risk vs. reward ratio along with the probabilities of being right vs. wrong, must be weighed very carefully with options. No matter how right you think you are taking a trade, there is a chance you could be carried out on a stretcher feet first if you are wrong with the aggressive implementation of options.
Related Tickers: SPDR S&P 500 (NYSE:SPY), SPDR Dow Jones Industrial Average (NYSE:DIA), iShares Russell 2000 Index (NYSE:IWM), Direxion Daily Small Cap Bull 3X Shares ETF (NYSE:TNA), Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA), ProShares UltraShort Russell2000 (NYSE:TWM), ProShares Ultra Russell2000 (NYSE:UWM).
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