Wednesday, November 14, 2012

XLI: Industrial breakdown

This has been one of those tantalizing days where stocks break below their 20-day price lows, sending a bear signal, but then almost immediately retreat back above the breakout point.

I would have 10 failing positions on my hands if I followed the classic Turtle Trading rule which says, Signal? Take it now. No waiting, and ask no questions.

Regular readers will know that a while back I modified the Turtle by adding a brake that I can tap lightly when a breakout occurs. When I see a signal, I set my alarm for half an hour later, and then see whether the breakout is still in place.

That saved me some future grief today.

At last, one signal stayed  below the 20-day price low, giving a clear bear signal that, under my modified rules, I could play.

The SPDR Industrial Select Index (XLI), an exchange-traded fund that tracks blue-chip companies involved in industrial production and services, fell below it's 20-day low of $35.99, triggering a bear signal.

The stock has been in a sideways trend since early September. From a low of $35.75 on Sept. 5, the price rose to $38.07 on Sept. 14, and then declined into a narrower range, running roughly from a floor of $35.99 to a ceiling of $37.54.

The break below has carried the price to $35.87 and so qualifies as a true breakout from that narrower range. The next downside resistance would be the $35.75 starting point for the trend.

Every business sector has a story. That of industry is of slow recovery from the recession valley amid a longer-term decline and the likelihood of serious cuts in government spending, including defense, whose weapons systems are a major part of American industrial production.

Over the past year, XLI has broken out to the downside six times -- once each in November 2011, and last March, April, May, September and October.

Excluding Wednesday's breakout, the seventh of the year, XLI has sent a bear signal on 2.4% of trading, and one breakout -- 16.7% -- has been profitable.

The net loss for the breakouts has been $4.66 per share.

One thing I look at in my analysis of past breakouts is, before a breakout occurs, the degree to which I expected it to result in a profit. In other words, how strong does the breakout look to me?

I do this by looking at the five prior days of trading -- a week back. For a bear signal, I count the proportion of those days that had a lower low compared to the prior day's low. (For bull signals, I count higher highs.)

Of the six breakouts, the successful one, on May 9, also had the strongest expectation, 80%. Today's breakout also has an 80% expectation. The failed trades had expectations of 40% and 60%.

So perhaps that high expectation level is a tell-tale for a breakout with a higher likelihood of success. I'm not willing to declare that a rule yet, but it's worth further study.

XLI on average trades 12.1 million shares a day, sufficient to give it a major-league selection of strike prices with open interest running to four and five figures and a front-month at-the-money put bid/ask spread of 1.9%.

Implied volatility stands at 19% in the lower half of the six-month range. Volatility has been in a sideways trend with increasingly wide swings since late October.

Options are pricing in confidence that 68.2% of trades will fall between $33.94 and $37.86 over the next month, for a potential gain or loss of 5%, amounting to 10 times the daily range. For the next week, trades are expected to fall between $34.96 and $36.84 for a 3% gain or loss, or five times the range.

Options are trading actively, with calls running 39% above their five-day average volume and puts at 8% above average.

The fair price zone on today's half-hour chart runs from $35.84 to $36.10, encompassing 68.2% of transactions surrounding the most-traded price, $35.94. The stock is trading within the zone below the most traded price with two hours of trading left before the close.

XLI goes ex-dividend in March for a quarterly payout yielding 2.22% at today's prices.

Decision for my account: I took the trade on the strength of the breakout to the downside. Plus I'm a sucker for ETFs -- no make-or-break earnings announcement risk.

However, there are plenty of reasons for caution, not least of which is the history of past breakouts. 

I've hedged the position, structuring it as a bear call vertical spread, long the December $36 call and short the December $37 call for a $40 credit per contract. The break-even point, $36.81, is slightly below the Turtle stop/loss of $37.09.


My trading rules can be read here.

And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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