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Here's Your Sign!

Written By Briton Ryle

Posted December 20, 2014

As a followfollow upup to Tuesday’s article on catching the next wave in equities, the breakout signal we were waiting for showed up right on cue. Over the past two days, the S&P 500 index has risen from 1,973 at Tuesday’s close to 2,061 at Thursday’s close for a gain of 88 points, or 4.46% in just two days.

But now that we have what were looking for, where do we go from here? And how can we best capitalize on this breakout?

Let’s first look at what the signal was and why it’s significant, and then follow up with a surefollow upfire way to capitalize on it.

Breakout Signal Right on Cue

The breakout signal we were looking for is composed of three distinct parts. For a detailed explanation, refer to my Tuesday article “Santa’s Coming to a Market Near You” ( upcomingfollow uptofollow upafollow upmarketfollow upnearfollow upyou/5497).

As a brief recap to save time, let’s quickly summarize the signal’s three parts:

• 1) On Tuesday, the S&P 500’s Slow Stochastic indicator registered below 15 (in purple below), indicating the S&P 500 was extremely oversold and, like a tightly coiled spring, was set to spring up as it usually has in the past (orange).

friday joseph graph1


• 2) The S&P 500 index closed Tuesday between its 100follow upday and 150follow upday moving averages (orange circle below). Over the past two years, the S&P had breeched its 100follow upday moving average 8 prior times (arrows). Of those 8 times, only once did it continue to fall through the 150follow upday moving average (purple box). The other 7 times, it did not penetrate its 150follow upday average.

friday 12 19 image 2


• 3) The S&P’s Moving Average Convergence Divergence (MACD) indicator was rapidly decending (orange box) toward negative levels, indicating that a turn around was close. In the past (purple), the MACD’s crossing into negative territory was followed by a sharp move up within days (arrows).

friday 12 19 image 3


All three parts of the signal were present by Tuesday’s close: an oversold stochastic, a close between the 100follow upday and 150follow upday moving averages, and a MACD in rapid descent toward negative territory.

All we were waiting for then was one sharp close up, where the S&P ended the day at or very close to its high for the day. This is significant because whenever this happened in the past (arrows above), the market stayed above that aggressive upfollow upclose for weeks to months.

Everyone knew that the Federal Reserve’s twofollow upday meeting which ended on Wednesday would give the markets a lift. But the magnitude of that lift was something we could only have dreamed of. Not only did we get one decidedly upfollow upclose on Wednesday after the FOMC’s press release and Chairwoman Yellen’s subsequent press conference, but we were gifted a second decidedly upfollow upclose the very next day on Thursday.

Thus, that signal we were looking for came not once but twice, something of a confirmation that we’re all set for a nice rally into the new year and beyond.

So how do we capitalize on this new wave upward? With careful use of leverage. But it’s not what you think. There is a safe way of using leverage to boost your profits.

The S&P ETF Swing

The simplest example on how to capitalize from the market’s next leg up is to select two ETFs, one leveraged and one not. The easiest ones to use are the SPDR S&P 500 ETF (NYSE: SPY) as your nonfollow upleveraged specimen, and the ProShares UltraPro S&P500 (NYSE: UPRO) as your leveraged choice (3follow uptimes levered, by the way). These are great choices because they are heavily traded which makes them highly liquid with narrow bid/ask spreads.

To begin with, select the amount of capital you want to put to work and divide it into two equal parts – half into the SPY and half into the UPRO. You must always be long both ETFs, and must never be short, as being short exposes you to unlimited losses. Should the market shoot upward overnight, you’d be waking up to one sorry mess on your hands if you were short.

As graphed below, with every move of the S&P 500, your SPY position (black) would match the market, while your UPRO position (beige) would move in the same direction by 3 times.

You simply follow the arrows downward. When the market has moved up and your UPRO position contains more value than your SPY position, sell some UPRO and buy some SPY. When the market has moved down and your SPY is worth more than your UPRO, sell some SPY and buy some UPRO.

In this way – by selling the leader and buying the trailer – you will be shifting your funds from the winner to the looser, preparing yourself to the next turnfollow uparound. This strategy is known as “relative value trading” and is also a form of “dollarfollow upcost averaged”, only in this case you are averaging between two stocks instead of the more common form of dollarfollow upcost averaging between cash and a stock.

friday 12 19 image 4


Two Cautions

But there are two cautions here which must be considered.

First, when using a leveraged ETF, do NOT buy on margin. Remember that the purpose of margin is to allow you to leverage your position, buying a larger position than you otherwise could with cash alone.

But since we are already using an instrument that is already leveraged, margin would only be increasing your leverage all the more, which could land you into trouble very quickly.

There is a safety mechanism already in place, however, in that the triplefollow upleveraged UPRO ETF must be purchased with at least 90% cash. So you really couldn’t use that much margin on UPRO even if you wanted to.

However, the SPY is 30% marginable, meaning that all you need to put down is 30% cash when buying SPY shares, allowing you to multiply the S&P index’s movement by 3.33 times. UPRO already gives you 3 times leverage as it is. And this relativefollow upvaluefollow uptrading strategy needs only one levered leg. In fact, the strategy cannot work with two equally leveraged positions. One levered position and one equalfollow upmarket position are required for it to work.

Yet there is a second safety mechanism of sorts built into the ETFs’ prices, which can save you a lot of money on the way down. Since no stock can fall below zero in value, your downside is limited to just the amount you put into your UPRO and SPY positions. Buying both positions on cash without using even a penny of margin will avoid margin calls should the market move substantially downward.

A second caution to consider is to avoid overtrading in close succession. The S&P index can move as much as 30% or more from low to high in a single year, equating to 90% for the UPRO. Since we never know ahead of time when the market will turn (well, sometimes we have a pretty good idea, as explained in the first portion above), still we can’t be certain that we are shifting funds from one ETF to the other at the absolute most optimum time.

We could shift funds today only to find they continue to deviate and present a better opportunity tomorrow.

The solution here is to stagger our shifts every 2 or 3 percentage points, with just a little shifted at a time. If we shift 10% of the position every 3%, we’d be able to continue shifting up to a total 30% move in the S&P, which should allow for plenty of time for the market to turn around before we run out of one of our positions.

Further on this point of staggering… notice in the graph above how the very last dip just a week ago would not have been caught by the trading system? While UPRO came close to touching SPY, it did not cross under it, and as such, we would have missed an opportunity to switch funds from UPRO to SPY in preparation for the nice rebound we saw Wednesday and Thursday.

This problem can be easily solved by staggering, where we trade every 2 or 3%. Zoomingfollow upin a little closer to the past 30 days as graphed below, we can see how UPRO plunged more than 14% from December 5th to the 16th, where the SPY dropped 5%. This would have given us at least 2 switching opportunities if we staggered 2.5% or less, or one good opportunity if we staggered from 2.5 to 5% between trades.

Thus, staggering allows you to capture trades between the two ETFs which would have otherwise been missed if you simply waited for those really big monthly or quarterly moves.

friday 12 19 image 5


Capture the Volatility

The recent breakout signal we were waiting for came right on cue, and will likely take us well into the new year. But there will be pullbacks along the way, as always. The relativefollow upvaluefollow uptrading method detailed here is one way to capitalizing not only on the market’s next wave up, but also from the volatility that will come from time to time.

Now we can generate profits when the markets climb as well as when they gyrate, capitalizing on the ups and downs of which there will be many. Using this system will make you look forward to those volatile pullbacks which other investors only dread.

Joseph Cafariello