Quick market update

If any of you subscribe to Dow Theory, you will notice the divergence between the Transports and the Industrials over the last several days as being a fairly significant bearish indicator. While the Industrials have managed to reach a higher high, the Transports have not.

Furthermore, despite all of the major economic reports being fairly positive of late, the S&P has still failed to rally. The old adage comes to mind, "if the market should go up, but it doesn't, that usually means that it's going to go down!"

And on that note, I chose today to buy some puts on SPY. Good luck all!

Are we due for a correction?

Factors in favor of a correction:

1. Summer doldrums. There's a lot of money away from the table - on vacation.
2. Overvaluation. Stocks in the S&P 500 are trading at their highest P/E ratios since 2004. This makes it very difficult for any more surprises on the upside to materialize.
3. Big spike in the Volatility Index (VIX) witnessed today, bringing us back to early July levels. VIX is a good proxy for perceived risk in the markets; thus, market participants are getting more scared...

Factors in favor of a continued upward trend:

1. There's a lot of money sitting on the sidelines. These investors are growing more and more frustrated about missing out on the rally that's been in progress since March, 09. They add support on the bid side everytime the market moves lower. What happened today?
2. Put/call ratios are actually relatively low, as of August 14, 09. This implies bullish market sentiment.

Factors that could fall on either side of the fence:

1. Economics. We continue to get bombarded by mixed reports on the state of the economy. However; the reports do imply that things are getting less bad.

In my own humble opinion, I believe at present the factors are more heavily weighted in favor of a correction at least through to the end of August. September will be a telling month when the big boys away on vacation come back to play.

How are we going to make money off this? I'm currently long, but I would still like to buy September puts on SPY.

Trading Resources

Ahead of a very telling week in the markets, I provide the following links that I have found to be very useful for trading:

• Barron's Econoday - Economic calendar dating all of the major events to occur throughout the week. Includes definitions and summaries.
• Level 2 Stock Quotes - Self explanatory. Free level 2's! Very useful for fine-tuning stops based on key support/resistance price levels.
• Sharpcharts at StockCharts.com - Best free charting platform online.
• StockTA.com - Does all the technical analysis for you!
• Guide to Swing Trading - Pretty much self explanatory.
• Santelli Trading - Awesome stock picker!

Portfolio Correlation

Further to my previous post (refer to Position Size, EDIT), I want to expand on managing correlation in your investment/trading portfolio in order to mitigate risk. I'm going to share something new I've been working on; let's call it Chris's Correlation Model for now.

I have attached a copy of the first draft. For the next version, I want to break down the cube into quadrants (maybe 18?); for example, one quadrant could be long x mid cap x early cycle. Like I said previously in Position Size , you generally don't want to risk more than 2% of your equity on any single trade. With this quadrant model, we can monitor the correlation in our portfolio and ensure that we don't have any more than 2% in a single quadrant, or essentially a single trade.

I realize that this isn't a new concept, and I admit that I am not fully versed in the ins and outs of portfolio management. Any comments/advice are welcome, or even if anyone can point to specific literature on this sort of subject - that would be very much appreciated. I would much rather adopt a tried, tested, and true model than develope my own. It's not like we're trying to re-invent the wheel here!

Note: I am aware of betas and individual stock correlation to the market. However, I didn't feel it was very suitable for any of the axes because I am looking for ways to differentiate stocks from eachother - and besides, as a trader, I think what you put on the axes is entirely subjective. Again, I'm not taking a hardline here and any advice would be more than welcome!

Position Size

A colleague asked me today, "how should I go about balancing my buying power among different stock trades?" I've read a bit on this particular subject, and what I've learned is that it's not so much about balancing 'buy-power' per se; it's more about balancing risk and return.

To do this, we use a simple calculation:
1) Define your risk in dollar terms. Most of the pro's recommend not risking any more than 2% of your equity on any one trade.
2) Chose a worst-case exit price, otherwise known as a strategic stop-loss based on some form of support/resistance (depending on which direction you're trading).
3) At point of entry, divide your risk in dollars by the difference between your entry and exit prices. The result will be the number of shares you can afford to buy at any given level of risk.

Example:
Your equity balance is currently $10,000. The maximum loss you are willing to sustain on any given trade is $200 ($10,000 x 2%). Stock XYZ is currently trading at $1.00 per share. Looking at charts and level 2 quotes of XYZ, you determine the nearest support level to be located at 0.91 - you set a strategic stop at 0.90. Therefore, the largest position you could take in stock XYZ is 2,000 shares [$200 / (1.00 - 0.90)].

A friend of mine at investcanada has recently posted a more indepth article on this topic here. Be sure to check it out!

EDIT: I want to add one thing here; don't forget about correlation! Entering long positions in five different small-caps each with a 2% equity risk tolerance might as well be the same as entering one long position with a 10% equity risk tolerance (2% x 5). We're all familiar with the saying, "a rising tide lifts all boats!"

Running on fumes...

It looks like the rally is running on fumes at the moment, as market news is drying up. I'm not sure what's left to keep fueling this rally higher as earnings season is winding down. According to an article at Bloomberg, stocks in the S&P are trading at their highest price earnings ratios in over 4 years (must be all that cheap money floating around)! The market is currently looking to the FOMC meeting on Wednesday and Wal-Mart (WMT) earnings end of week.

I picked up some shares in IO and NCS this morning. My call options on MGM and WMT are up, while my calls on AMZN are almost worthless - market sentiment on Amazon seems extremely bearish at the moment for reasons I'm not aware of. I'm still considering picking up some puts for some insurance from a broad decline in the overall market.

Well, another late night for me. Time to hit the sack!

Welcome to Market Gladiators!

This is where we duke it out to see who can make the most money in the markets!

I'll be posting daily market recaps and short, medium, and long-term forecasts on where the markets are headed. As I currently still have a day-job, I'll be sticking to equities markets for now (TSX, NYSE, NASDAQ, etc.). For my posts, I'll be drawing on my education in business, economics, and political science, along with my own experiences trading equities over the last couple years.

That's all for now. So until tomorrow night, good luck all! Let's make some money!