The execution of well-conceived trade is proceeded by several steps including an evaluation of the underlying fundamentals, the development of a trade idea based on those fundamentals and then using the price movement of your chosen vehicle to determine the optimum entry and exit prices.
Usually, the key difference between a profitable trade and a loser is the timing of the trade. I’ve been reminded over the last week of the importance of timing in my own trading.
In The Whaley Report on January 27, I pointed out the benefit of nailing the timing of trade when we shorted FXI in the hours just before a huge 2-day selloff. So this week, I’ll discuss the flipside -- what it looks like when a trade is entered and the timing is poor.
My opinions of US growth are well documented over the last couple of months: Its not deteriorating but it is definitely slowing.
Inflation is accelerating this year in the stuff people buy: gas, coffee, corn, milk, etc. Disposable income and savings have been falling for several months while consumption has been accelerating.
The US consumer is going to run out of ammunition at some point and at the very least, won’t be able to maintain the current pace of consumption. So, one of the themes I’ve been trading for my asset management firm is being SHORT consumer related stocks and indices.
Tale of A Trade
To that end, I shorted the Consumer Discretionary SPDR exchange-traded fund, XLY, Friday, February 7.
To set the stage, I’m going to walk you through the different aspects of the trade I evaluated before deciding to pull the trigger and initiate the trade. From a fundamental perspective, I’ve discussed the myriad of slowing US data starting with the report on January 20.
In addition, I’ve discussed all the ways that inflation is accelerating and “taxing” the US consumer on basic needs that people purchase. Based on all of that data and the general trajectory of US growth, the consumer and specifically companies reliant on the US consumer will disappoint over the next couple of months.
Heading into that Friday, we received several important data points, all of which signaled further weakness in the economy. I outlined them in my February 10 report: ISM index declining and the new orders index declining the most since 1980 and several jobs numbers that showed the labor market was continuing to cool off.
XLY had rallied close to 2% on the week despite all of this data. This rally occurred on below-average daily volume and after February 3, when XLY declined 2.5% on volume that was 385% above average. That’s right, nearly 4 times the average daily volume.
That’s a huge divergence.
From a technical perspective, this looked like a classic low-volume, low-conviction dead-cat bounce, which generally follows a high-conviction sell-off like XLY had experienced.
The sell-off had also broken XLY’s 7-month uptrend. Friday’s rally pushed XLY right back to the underside of that trendline but it couldn’t manage to close back above that trendline.
Timing Is Almost Everything
In my experience, there are few trades that offer a better set-up than what I was looking at with XLY. The fundamentals favored my SHORT bias and the technicals were setting nicely for a SHORT trade to be initiated before the next leg down.
I initiated the trade at 10:34am at a price of $63.54. Before I breakdown what has happened with the trade, it’s important to point out that whether a trade was timed well or not is strictly a matter of hindsight. But you should be in the practice of evaluating the timing of your trades to determine if there are gaps or weaknesses in your process that can be improved.
Back to the XLY trade. I SHORTED XLY at 63.54 usingan ALPINE line of 65.28 as the risk price and an ABYSS line of around 58 as a profit target. I was risking 2.6% for an opportunity to make 9%, or a reward-to-risk ratio on the trade of 3:1. The first mistake I made was initiating the trade during morning trading.
With a few exceptions I generally close and initiate trades as close to the closing price as I can. The closing price each day is the most important price for a particular security because it’s the price at which traders are willing to take home positions overnight. That goes double for Friday’s closing price because traders are carrying those positions over the weekend.
XLY closed that Friday at 64.09 putting my trade immediately in the red by 0.9%. If I had followed my general protocol of waiting until closing to initiate this trade I could have reduced my risk on the trade by one third.
That said, the fundamental data this past week continues to back up my view that US growth is slowing and that the US consumer is slowing down. The most important of these data points was the Retail Sales number for January declined month over month from December, and December’s sales number was revised lower from the original 0.2% growth rate to a -0.1% from November.
January’s year over year growth rate was the lowest since 2009 and the 2-year growth rate was the lowest since 2011. In addition to retail sales, weekly unemployment claims decelerated for the fifth consecutive week in a row, showing that the US labor market is continuing to languish.
No Such Thing As A Sure Thing
So how did XLY respond to this negative consumer related data? XLY gained an additional 1.7% last week on volume that was 10% below average. And I was forced to close my position in XLY on Friday for a 2.8% loss.
Did I have the wrong bias on XLY? No.
Did the fundamental underpinning to my SHORT bias on XLY change last week? No.
Did the technical picture for XLY change last week? Slightly.
Am I changing my bias on XLY for the upcoming week? No. I walked you through this trade for two main reasons.
One, I thought it would be helpful if I walked you through an entire trade soup to nuts so that you could understand the way I approach a particular trade.
Second, I wanted you to see that a trade can look picture perfect based on your process but the timing dictates whether you make money or not.
The market is a complex, dynamic system. Short-term price movements are dictated by investor sentiment and technical considerations, which are relatively unpredictable. The intermediate- to long-term price movement is dictated by the underlying fundamentals of a particular security, which is more predictable.
The key is to use the short-term price movements away from the fundamentals to position yourself for when a particular market moves back towards the fundamentals. But do so using solid risk management techniques like ALPINE and ABYSS lines to keep you in the game.