Today’s Trading Lesson From TradingMarkets

Editor’s Note:

Each night we feature a different lesson from

TM University. I hope you enjoy and profit from these.
E-mail me if you have any
questions.

Brice

Using RS Lists to Aggressively Trade on Long and Short Sides

By Mark Boucher

TradingMarkets.com

One of the most
important lessons that a
successful stock investor needs to learn is that there are times when the
market is presenting plentiful, low-risk opportunities and there are times
when making money in the markets is quite difficult and far less certain.
Adjusting one’s strategy for these different market environments is key. You
can trade aggressively in a terrific market environment and make
triple-digit annual gains with ease. But trading just as aggressively in a
very difficult market environment could result in a huge drawdown of
capital. Remember that a 50% drawdown erases a 100% gain, and requires a
100% gain just to get back.

Over the years, one of the most
common stories I’ve seen is for a smart investor to begin investing very
aggressively during a strong market run-up when the environment is fairly
easy pickings. This smart investor will have a strategy that exploits the
good environment quite well — and he’ll typically make huge gains of around
500%-1,000% on his money in a one- to three-year period. But when the market
environment changes, this investor refuses to change with it, and in the
following one- to two-year period, the investor loses most or all of his
trading capital. Witness Foxhound funds’ recent wipeout — a leveraged 300%
gain in 1999, but a total 100% loss of everything by April, 2000.

Clearly, learning to understand
when one can be aggressive, and to understand when to be defensive is
important to investors desiring to maximize gains with minimum risk.

We’ve already discussed (in prior
lessons and courses available on TradingMarkets.com) some macro tools
investors should watch — like interest rates, market breadth, and timing
models both short and long-term — to help distinguish an environment
conducive to aggressive vs. defensive trading. In addition, investors should
watch carefully the number of flag and cup-and-handle breakouts or
breakdowns in stocks with upfuel or downfuel to see how abundant the
market’s opportunities are.

Probably most importantly,
investors should watch carefully our daily list of

Top RS New Highs (on TradingMarkets.com) and the groups and sub-groups
based on this list as well as the

Bottom RS New Lows and the groups and sub-groups based on it. When the
list of Top RS New Highs is more than 20 stocks every day and there is clear
leadership in several groups that are broadening with more and more new
highs in that group each day, the environment is more conducive to
aggressive buying. Conversely, when the list of daily Bottom RS New Lows is
more than 20 stocks every day and there is clear downside leadership in
several groups with more and more new lows in those groups each day, the
environment is conducive to more aggressive shorting. When Top RS New Highs
and the number of issues in leading groups thin out, the environment is one
to become defensive toward on the long side. And when the Bottom RS New Lows
and the number of issues in lagging groups making new lows thins out, the
environment is one conducive to becoming defensive toward the short side.

“…in early March…we advised investors to take half profits on all positions. Leadership was failing and the opportunistic environment was at a sea change.”

Until early March 2000, both the
short-side and the long-side showed broad participation and seemed to be
indicating an aggressive posture. However, beginning in very early March,
the environment began to change abruptly. Top RS New Highs began to thin out
to under 20 issues and the leading groups began to show fewer and fewer new
highs. Similarly on the downside, Bottom RS New Lows began to thin out to
under 20 issues and the lagging groups began to show fewer and fewer New
Lows. This is why, in early March, when we had been previously advising
fully leveraged shorts and longs, we advised investors to take half profits
on all positions. Leadership was failing and the opportunistic environment
was at a sea change.

Since early March, the stock
market environment has changed. There is no clear leadership on either the
upside or the downside. In addition to reducing leverage, tightening up
trailing stops, and taking 1/2 profits on all positions, investors need to
trade more defensively in their approach going forward until a better
environment returns.

In future lessons, we’ll discuss a
number of ways of becoming more defensive while still leaving ample room for
profiting from market movements. But a huge part of knowing when to trade
aggressively and when to cut back is revealed simply by watching carefully
the breadth and number of flag breakouts and cup-and-handle breakouts to new
highs in stocks with upfuel on our Top RS New Highs list — and in watching
the leadership and breadth of stocks and groups on these lists over time.
Similarly, a huge part of knowing when to trade the short side aggressively
or when to cut back is revealed simply by watching carefully the breadth and
number of downside flag breakdowns and downside cup-and-handle breakdowns to
new lows in stocks with downfuel on our Bottom RS New Lows list — and in
watching the downside leadership and breadth of stocks and groups on these
lists over time. These lists are some of the most incredible tools available
to investors anywhere.