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Wednesday, March 26, 2008

Money left on the table - a cautionary tale

Yesterday I was stopped out of my position in the ProShares UltraShort FTSE/Xinhua China 25 ETF (FXP).

I managed to obtain an 18% gain on the trade in FXP but this is actually a pretty lousy result because there were other opportunities to sell at a much better price. Why didn't I? Because I ignored my rules for trading.

Trading is not like buying and holding for the long term. Nevertheless, both types of investing should be pursued with a set of rules, a discipline if you will, that guides your decisions. The rules may be different in these two cases but you should define your rules and stick with them. Unless, of course, they seem to get you into trouble on a regular basis in which case perhaps they should be revised.

First, let's talk a little about the rules I try to follow. They're pretty simple and not particularly original but they are what I use. Here they are:

Stops should be employed at all times. Support and resistance levels should be looked at in order to determine stops. Also look at trend lines and moving averages. Stops should be re-evaluated and updated as a stock moves up.

Stops must be really wide for Ultra ETFs.

Don't chase performance.

You must have an exit strategy when you initiate a trade. The exit strategy must always take into consideration what kind of gain is reasonable for a trade as opposed to a long-term buy-and-hold. Stops or trailing stops should be part of the exit strategy. Put some time into getting familiar with the stock's chart.

Avoid buying or selling in the first hour of trading. Sometimes, when economic data is released before the opening bell, this rule can be broken but only if you are confident the data will support one-way trading that day.

Look at over-bought and over-sold indicators (RSI, Bollinger Bands) when looking to time a trade. This goes back to the rule about not chasing performance. Be patient!

So what rules did I break with the FXP trade?

To begin with, I ignored my exit strategy. Since FXP is basically the double inverse of the iShares FTSE/Xinhua China 25 ETF (FXI), it seems reasonable to track FXI when trying to determine expected moves in FXP. In looking at FXI, I identified several support levels. I waited patiently for FXI to violate one more support level at around $140 and drop down to the next level below. I had decided that at that point, it would be time to sell FXP. As FXI began to move in the expected direction, I needed to answer some questions to validate my exit strategy: Was there a chance FXI would break down below this new lower support? Was my gain on the FXP trade at this point good enough? Would holding on for the next leg down in FXI be too risky and jeopardize my hard earned profits?

The correct answer would have been that current profits were good enough. FXI had already fallen over 30% from its peak and the easy money had been made on the short side. Accordingly, FXP had hit a new high and the profit on my trade, having opened the position at $86, would have been in the neighborhood of 30% to 35%. That was a reasonable gain. In order to preserve this gain, this would have been the time to tighten stops. Which leads me to the next rule that I broke.

It's true I had a wide stop in place but I had not re-evaluated it as FXP surged upward. When the markets began to bounce off their recent lows last week, FXP fell fast and hard. Now I was in a position where I was worried about preserving some kind of profit. This is when I was stopped out of the position.

So the moral of the story is that you must be willing to put in the effort to maintain a discipline or you should avoid trading for the short-term. As for myself, I hope I have learned a lesson from this experience.

Postscript: So this morning I saw an opportunity for a quick trade in the ProShares UltraShort Financials ETF (SKF). There were a number of news items that I knew would affect the financials: downgrades, estimates of further writedowns, slashed earnings estimates, the Clear Channel deal falling apart and the bad Durable Goods report. SKF had fallen right down to its trend line. I bought just after the open at $107. The ETF closed at $110.98.

So did I follow my own rules? The ETF was certainly not over-bought, so that was good. It looked like it couldn't be any lower and still be a buy. I did buy at the open instead of waiting but, given the news, it seemed the day's trade would go in a consistent down direction. My exit strategy is more conservative than it has been in the past with this ETF. Instead of expecting the ETF to rise to the $140 level again, I intend to tighten stops considerably as the ETF gets to the $120 level. We'll see how this plays out.

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