With the recovery in the stock market well under way, it's definitely a
bull market right now. Some observers are cautioning that it's a false recovery; however, there's not much downside left in some financial stocks and stocks that have been hit by a lack of consumer spending power, and I think the chances are high that this recovery will take hold or at worst, get delayed by a limited downswing in short term.
This seems like a good time to build positions in some of the stocks that have gotten hammered in the past year and that are now showing signs of recovery; as long as the fundamentals are good, we're going to see them rise for the medium term or even long term. At the same time, it's important to keep a cushion in cash to take advantage of any buying opportunities that a sudden downward swing may bring.
One place to find these beaten-down stocks is among the components of the S&P 500. These are typically companies that have been solid bets in the past, and while some of them have seen share price declines due to new technology advances or changing market conditions, others have been hit simply by the overall general decline. These latter companies are a good bet for a quick recovery.
When evaluating a stock under these conditions, I look at the following indicators:
- Identify stocks with a strong upward growth pattern
- Select the ones I feel good about: companies I know or ones that after research seem promising, and that are not too small or too volatile
- Specifically, select the ones that are part of some global or industry-wide upward trend (see examples below)
- Look at the fundamentals of the company: overall revenues, margins, last quarterly results, when the next quarterly results are expected, etc.
- Whether the technical aspects are favorable: trends in the 3-yr, 1-yr and 3-mo chart, support and resistance, MACD, 20- and 50-period EMAs
- Overall stock price between 5 and 35 (this range just happens to fit my overall account size)
As an example of #2, , defense spending is likely to fall during a Democrat administration (such as now), and most good stocks in banking, real estate, consumer goods, alternative energy and 'green' initiatives are likely to rise over the next few years.
There are three simple ways to play a significant bull trend:
- Buy OOM calls a little above current value, for 1.5 to 2 years out
Since the calls decline at a much faster rate than the stock itself, an automatic contingent sell order does not work very well; by the time it triggers, the option has gone much lower than warranted (unless IV rises very fast). The risk management should be built into the purchase by only buying calls for an amount twice what can be risked, and then you can set up an automatic sell for the option if it falls to 50% in value. If the option rises, the best time to sell is when it is ATM, or six months into the trade as the time value starts declining more rapidly; you can then reevaluate whether to buy another one or look for another stock.
- Sell OOM puts below the next level of support
This is much simpler. For stocks that you would like to own anyway, you can set up an OOM put at a purchase price you're comfortable with, around 6 months out. If the stock goes down and it gets triggered, you purchase the stock; if the stock goes up, you either buy to close, or purchase an insurance put underneath it at a much lower price. This lowers your profit margin, but frees up collateral tied in with the naked put. Ideally, the option expires worthless.
- Buy the stock
This is the simplest. Buy the stock and set up a stop-loss order; as the stock moves higher, change the stop-loss order to move up with it, so that it gets triggered whenever there is a significant change in the upward direction. When you get stopped out, you can reevaluate getting back into this stock versus another one.
If you pick the right stocks, then each of the strategies above should be profitable as the stock rises; if it falls, the damage should be limited. Ideally, if the bull market continues, most or all of the stocks will rise producing an overall profit.
Finally, remember the common saying on Wall Street: "
Don't confuse a bull market with brilliance!" So even if you do well during the current broad rally, remember to change strategies once the rally ends.
Happy trading!
