Markets I Trade: February 12, 2019

In my non-registered investment account I am developing my trend following strategy continuously. I don't pretend to have all the answers; I am always exploring and learning and I am sharing that journey with you on this blog.

All I know for sure is that I want every trade to end in three ways: a small loss, a small gain, or a large gain. I predetermine my risk on each trade and aim to make sure that risk is never exceeded.

A big focus of my trading is to expand my access to a broad range of markets while using my investment capital very efficiently. Instead of holding standard positions in ETFs or stocks, I am using LEAPS options and futures contracts.

Options and futures contracts allow me to bet on the upside or on the downside of trends with minimal penalties. They also require a small capital allocation to control a large position. Unlike with common stock or ETFs, options and futures do not require borrowing costs to short an asset.

I try to limit my investing process to liquid markets that have the highest potential for bigger price movements. This generally means using LEAPS options on the largest ETFs and using futures contracts for commodities and currencies.

Thanks to the wide range of choices in the ETF markets and the massive breadth of the futures markets, I can theoretically get easy exposure to hundreds of different assets across the planet.

To monitor each instrument I trade, I look at moving averages and volatility measurements. Although there is no holy grail indicator, looking at these tools can help paint a pretty solid picture of where the markets are going. This can improve the odds of success in trading.

Moving averages help identify the direction of trends and can help show turning points in direction. Using volatility measures makes it easy to size each position based on pre-determined exit points. High volatility markets translate to smaller positions while low volatility markets allow for larger positions.

I also look at breakouts, although I am not using them to enter or exit positions. Breakouts can be very helpful in confirming trends and seeing points of previous resistance.

U.S. Small Cap Stocks (IWM)

In today's post I will share my analysis on my recent long position in U.S. small cap stocks. I used out-of-the-money LEAPS call options to execute this trade. I like using options were possible because the level of risk control is unparalleled.

As we know, the U.S. market suffered from a relatively strong correction from October through December 2018. Among the areas hardest hit were U.S. small cap stocks. This didn't surprise me. As I have noted in prior posts, U.S. small caps are some of the most expensive areas of the stock market.

U.S. small caps are also a good reflection of the domestic U.S. economic performance and stock market breadth. If small caps are doing well, chances are the American economy is doing well, the S&P 500 is doing well, and the Dow Jones Industrials are doing well.

As the U.S. markets recovered in January, I took a position in small caps based on the Russell 2000 index. As investors we cannot buy an index, but we can buy ETFs or futures which track the index. In this trade I used LEAPS options on the largest Russell 2000 ETF which trades as IWM.

In general, I prefer using LEAPS options to any other financial instrument. This is provided that liquidity is reasonable and volatility costs are not insane which inflates the premium cost of options.

Although I don't have any particular issue with the S&P 500 (SPY) or NASDAQ-100 (QQQ), I chose to get exposure to U.S. stocks via small caps in this case since it suffered from the biggest correction and has the best reflection to the U.S. economy which is doing quite well by most measures.

Although I try avoid fundamental analysis, I would admit this selection is a bit of fundamental-style guesswork in attempt to pick the preferred method to get exposure to U.S. stocks.

Russell 2000 Index (Weekly Bar)

Source: StockCharts.com

The Russell 2000 trade I made is what I would consider to be a lower conviction trade. We are taking a position into a declining long-term moving average and this could easily just be a short-term rally. However, my signal stated "take the position" so I followed the rule and will exercise caution.

At the end of December, the Russell 2000 was technically oversold and, as expected, prices rebounded from that low. In general, looking further back into 2017 and 2018, we've seen great strength in U.S. small caps and it truly has been a great area for investors.

In early January prices began to move upwards strongly and this is where I took my position. It is currently seeing a nice profit and the Russell 2000 has done very well compared with the other U.S. broader indices.

Upside Optimism

  • The Russell 2000 moved up from a technical oversold period which can indicate a longer term bottom.
  • The price jumped strongly over the 10-week SMA and is now approaching the 40-week SMA at 1580.
  • Although the upside move has been relatively strong, the Russell 2000 is far from being overbought.
  • We saw a deep MACD crossover, similar to 2016. Last time this was followed by a strong uptrend.

Upside Caution

  • The price is below a declining 40-week SMA indicating a long-term downtrend.
  • This is the first time the 40-week SMA turned negative since 2016.
  • The Russell 2000 hasn't gone through a correction like the late-2018 move since 2015.
  • Betting on a pivot point (change in direction against the long-term trend) always has more risk than buying into a confirmed uptrend.

Russell 2000 (Daily Bar)

Source: StockCharts.com

This chart shows my entry point (blue) and my current stop level (red). Price volatility seems to be slowing, so my stop should move up slowly with the price if a sustained up-trend materializes.

I entered this trade using out-of-the-money LEAPS call options on the IWM exchange traded fund. IWM options are very liquid. The strike price is $160 on my IWM options (roughly corresponding to a Russell 2000 index value of 1630).

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