A New Way To Analyze Risk

A New Way To Analyze Risk

It was another wild week for the stock market as very strong earnings from three tech giants, Amazon.com (AMZN, Alphabet (GOOGL) and Microsoft (MSFT) combined with the House acceptance of the Senate’s budget sparked a fuse under the tech sector on Friday.

Over the past few weeks I have been too cautious on several of these tech giants as I felt the risk was too high to be a buyer going into their earnings reports. In many years of teaching traders as well as professionals around the world I have found that the biggest losses often occur when one concentrates on the reward not the risk of any investment.

Just this morning I was told by my plumber of his friend who had acquired a large position in Bitcoin that probably made up over 80% of his net worth. He had no plans to sell as he was expecting them to rise another 60-100% to $10,000-$12,000.  My advice was to develop a plan where he scaled out of his position as prices moved higher.

Now I rarely talk about bubbles as I have seen very few in over 35 years but I think bitcoin will eventually qualify though it could reach his targets first. In my market analysis and teaching about technical analysis I have focused on limiting the risk rather than concentrating on the potential reward.

In real terms this means that I am willing to miss out on the last part of a rally in order to avoid taking too large a loss if the market reverses. One of my favorite tools for assessing the risk are the Stoller Average Range Channel or Starc Bands developed by the late Manning Stoller.  In addition to be an excellent and very experienced trader he was often hired as a forensic trading accountant to unravel some of the many large trading disasters.

The starc band formula is:

Starc+ = 6-period moving average + (2 x 15-period Average True Range) (ATR)
Starc- = 6-period moving average - (2 x 15-period Average True Range) (ATR)

The Average True Range (ATR) was developed by Welles Wilder and a fourteen period ATR is used for starc bands.

I have written extensively about the starc bands and I want to emphasize that contrary what you may read on the internet they are used in a totally different way than either the Bollinger Bands or Keltner Channels.  In Manny’s work bands calculated using two times the ATR above or below a moving average should identify 90% of the price activity.

Therefore when prices are above say a monthly or weekly starc+ band than the risk is high in buying at that level. Conversely if prices are at or below the starc- band then the risk is high at selling at that level but the risk is more favorable if you are a buyer.

This does not mean that prices cannot go even higher or lower but the odds of a reversal are high and increasing the longer you are above the weekly or monthly bands. Those of you who have followed the gold market may remember when it moved above $1000 for the first time in March 2008.

Fears of inflation were high and many were convinced that stocks had started a new bear market.  On the monthly chart of comes gold futures I have plotted the 2XATR starc bands (in green) and the 2.5ATR starc bands in blue.

Gold moved above both bands in January, February and March of 2008. Gold had a high of $1033 in March but closed the month at $916. This was the start of an eight month decline that dropped prices by 34%.

From the late 2008 lows gold had a magnificent rally that took prices from a low of $681 to a high of $1923 in September 2011. During both August and September of 2011 prices exceeded both bands (point 1) even though it may not seem that way on the chart. The bands are determined at the end of one prior for the next period but can rise until the next period is over.

For September the monthly bands based on August’s data were at $1802 and $1857 so the high on September 6, 2011 of $1923 was well above both bands. In a Forbes article published on August 18, 2011 “Gold Bulls – Protect Your Profits” I commented about the “historical high risk buy level of current gold prices basis the starc band analysis”.

It should also be pointed out as the chart indicates the gold futures had exceeded both starc+ bands for three weeks before the highs were in place. The sentiment was very bullish at the time as some were looking for gold to reach $5000-$700 in the next few years.

I pointed this out at the time “As gold has powered to several new highs over the past two weeks, the only thing missing has been analysts who are voicing even a short-term bearish outlook for the yellow metal.” As the chart indicates gold prices dropped to a low of $1321 in April 2012 as prices were below both monthly starc- bands.

This is not meant as a change in my long term bullish outlook for stocks as I do not see the market at such a high risk level as gold was in 2011. As long term readers know I have been bullish on the stock market since the spring of 2009.  I was recommending new buying near the correction lows in 2010, 2011, 2013 and 2016. Over 1400 posts can be found on Forbes for you insomniacs, just click on Archive.

There are no warnings yet of a bear market or even a significant correction (over 10%) based on my advance/decline analysis. The point I want to make that it is not the time in my opinion for investors to be buying the broadly based market ETFs. I think there is likely to be a much better risk buy point in the weeks or months ahead.  As I discussed a few weeks ago (Don’t Make These Investing Mistakes Now) chasing prices is a common investing mistake.

The Dow Jones Industrials is the most extended of the major averages as it is currently above both starc+ bands for October as the 2.5XTAR is at 23,389 and it closed Friday at 23,434.  For the second week the weekly 2XATR band has also been exceeded. This should be noted by those who are long the SPDR Dow Jones Industrials (DIA)

For Viper ETF subscribers I make recommendations for both investors and traders. Before any recommendation I define a good entry level (always use limit orders) and where an out of danger stop can be placed. There are still several ETFs that have been lagging the market and look ready to become new market leaders.

As the Spyder Trust (SPY) and PowerShares (QQQ) are making new all-time highs late Friday the Dow Industrials are only up slightly and the broadly based NYSE Composite is up 0.1%.  This excellent market screen from the WSJ shows how the market stood 30 minutes from the close.  The A/D numbers are positive but not extremely strong even on the Nasdaq Composite with 1826 advancing and 1047 declining.

As for individual stocks there are more favorable trades as long as you can avoid the earnings reports which have often been treacherous.  Viper Hot Stock traders exited positions last week in Netflix (NFLX), Applied Materials (AMAT)  and PRS Health Services (PRAH)  for nice profits (see Tweets NFLX and PRAH) Only AMAT is now higher.

One of the biggest losers last week was Chipolte Mexican Holdings (CMG) as it looks ready to close the week down almost 15%  Both the weekly relative performance and on-balance-volume turned negative on June 16th, line a,  when CMG closed at $450 which is 64% higher. The indicators are making more  new lows and show no signs of bottoming. The weekly starc- band for next week is at $260.60.

So once you look at Friday’s action or see the parade of CNBC analysts telling you to buy now take a look at how far the stock or ETF is above good support. Calculate the risk first before looking at the reward and it may convince you that it is a better idea to wait before you buy. Patience is a trait on many successful investors.

In my Viper ETF Report and the Viper Hot Stocks Report, I provide market analysis twice a week along with specific buy and sell advice. New subscribers receive five past trading lessons for just $34.95 each per month.

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