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By: Chris Rowe — October 5, 2009

How to Bet on 2 Sectors' Strength

Yesterday was a huge day, technically. 

Why?

Thursday's and Friday's action brought the market back down to its major uptrend line (for the first time since mid-July).  Pullbacks to the uptrend line (green line) are healthy and are just an expected part of an advance.

The trendline tends to act as support (green arrows).  On Friday, the market moved lower intraday, bounced off the trendline but then recovered, which is one sign of strength when at such a key level. 

Friday left traders wondering if Monday would either show a follow-through and confirm Friday's intraday reversal, or be a down day -- spelling trouble for the bulls. 

If we had a down day, it would have pushed the market below that trendline, which would have negated Friday's intraday reversal, and this would have been a signal that the market would most likely continue lower. 

Of course, Monday rolled around (yesterday) and we got the rebound the bulls were hoping for. 

Not only did we bounce off of an uptrend line yesterday but, at the same time, we pulled back to the 50-day moving average (light blue line). 

The 50-day moving average is the major moving average that traders focus on, to see if the trend is strong (where the market regresses back to it before continuing on), or if the trend is weak (where the market would dip far below it). 

A strongly advancing market could pull below the 50-day moving average and still continue higher. But when the market pulls back to the 50-day moving average and then bounces up without even penetrating it, traders view that as a sign of strength ... and this breeds confidence in the next advance. 

Finally, there is an old horizontal resistance level (blue line) and old resistance levels tend to act as new support.  So we had three major stars aligned that were important to the strength of this market, and the market said the bulls still have the ball. 

HOWEVER...

We still have a Moving Average Convergence/Divergence (MACD) sell signal.  The market COULD decide to change its mind and violate all of those key support levels. 

Anything can happen.

Instead of betting on direction, you can bet on strength...

You don't have to be absolutely right on a trade in order to make money in the stock market.  You only have to be more right than wrong

I'll get to that in a second, and I'll spell out a money-making strategy that the professional fund managers use, and you can use just as easily.

One of the easiest ways to make money in the stock market is by using Exchange-Traded Funds (ETFs).  For those of you who've been chained up in the attic for the last decade, an ETF is a tradable security that represents a group of stocks, just as the Dow Jones Industrial Average represents 30 stocks.

In fact, the ETF called the "Diamonds" (Symbol: DIA) is the security that mimics the performance of the most popular U.S. stock market index: The Dow Jones Industrial Average. 

Enough Stock Market Pre-School. 

Back to only having to be more right than wrong...

Today I'm going to talk about two sector ETFs: one that probably trades higher, and one that probably trades lower. 

You can profit from both of them, since you can profit from either the advance or decline of a security. 

But what would happen to each ETF if the general stock market traded much higher?  What about much lower?

I'm an ex-money manager from Wall Street, and the way we made millions back then is the same way we do it today: hedging our accounts

The term "hedging" may sound intimidating to the novice, but it's an incredibly simple concept that you'll definitely understand in five minutes from now. 

In fact, you'll start profiting from it! 

The Hedging Edge

IF the market moves higher:  Right now, odds are in favor of an advance in computer stocks, software stocks and telephone stocks.  In other words, I think the tech sector looks pretty good. And if the market moves up, tech could lead the way.  So, we want to find a "sector ETF" that works for us. 

There are quite a few, but for the strategy I'm going to give you right now, I'm going to use the Ultra Technology ProShares (Symbol: ROM). 

What's special about this ETF is it actually multiplies the returns by 2.  So, it tries to correspond to twice the daily performance of the Dow Jones U.S. Technology Index. If the Dow Tech index is up or down 10%, this ETF should move up or down 20%. 

IF the market moves lower:  I'm a pretty big hater of oil stocks.  Crude looks like it wants to pull back, and the sector has been showing many signs of weakness. 

An ETF that can allow us to take a bearish position in the oil and gas sector is the UltraShort Oil & Gas ProShares (Symbol: DUG).  This ETF attempts to correspond to twice the inverse of the daily performance of the Dow Jones U.S. Oil & Gas Index.

If the Dow Jones U.U. Oil & Gas Index moves 10% in either direction, this ETF should move by 20% in either direction

I think technology stocks could outperform the general market and oil stocks underperform the general market whether the general market trades up or down.

Strength in Numbers

We aren't going to bet on the direction of any one stock.  To take it a step further, we aren't even going to bet on the direction of a group of stocks.  We are going to bet on the relative strength of a group of stocks.

What we'll do is reduce the individual stock risk. (A company, in a strong sector and strong market, can still trade lower if the SEC investigates them for accounting fraud.)  Then we will eliminate the risk of being wrong on the direction of the general stock market (because we will make both a bullish and a bearish bet at once).

One Way to Play

How will we do this?  There are two ways.  One way is more common (and less sophisticated), and that is to buy both ETFs using the exact amount of money for both positions

For example, we can buy $10,000 worth of ROM and $10,000 worth of DUG.

  • The goal, if the market moves higher, is that the technology sector will move up BY A LARGER PERCENTAGE GAIN than the oil and gas sector. 
     
  • The goal, if the market moves lower for example, is that the oil and gas sector will move down by a larger percentage loss than the technology sector. 

If we hit a grand slam here, the tech sector will advance while the oil and gas sector declines. 

Here, we just want tech to outperform oil and gas.

The reason we chose the "Ultra" ETFs (one that mimics 2X the tech sector's performance, and another that mimics the INVERSE of 2X the oil and gas sector's performance) is we are taking two positions at once and considering them as one position. 

Look at the math below:

Bullish Tech $10,000 investment
Bearish Oil  $10,000 investment
Total           $20,000 investment

If tech declines by 10% and oil declines by 20%, that's a 10% difference, right?  But that doesn't mean a 10% gain. 

On the total position, that's only a 5% gain. 

Why?

Bullish Tech lost (10%): $1,000
Bearish Oil lost (20%): $2,000 (which is a gain for us since we were bearish).
Net result:         Gain of $1,000

And $1,000 profit on a $20,000 cash outlay is just 5%.

So we play the "Ultra" ETFs, which move twice as fast, and this allows us to realize the entire difference as a profit.  This way, the result above will net us a full 10% return. 

This may surprise you, but many studies show that, over long periods of time, volatility doesn't really give you a larger or smaller profit (unless you are spun out of the market at the wrong time due to volatility causing you to sell at the bottom and buy at the top -- in which case volatility creates a larger loss). 

In other words, there really isn't much point in looking for the huge gains, which can also turn out to be huge losses. 

Don't sneer at 10%.  The reality is that the sector moves can and probably will give you a much larger reward.  A 30% or 40% profit is definitely very possible. 

Another Way to Play

I told you there are two ways to play this.  One way is more common -- the way we just discussed.  The second is more my speed, and gives a higher reward/risk ratio. 

I like to trade options instead of stocks or ETFs.  The big question is always, "Which options would I chose?"

In this example, I could be a buyer of the ProShares UltraShort Oil & Gas (DUG) April 12 Calls (Symbol: DZG DL), and a buyer of the exact same dollar amount of the ProShares Ultra Technology (ROM) May 35 Calls (Symbol: ROM EG).

Why does this have a higher reward/risk ratio? 

Because these options will almost certainly gain more when we are right than they will lose when we are wrong. 

If ROM trades 10 points higher (ETF up about 25% because tech traded 12.5% higher) in three months, the option will probably trade from $9.50 to $18 (up 8.5 points).  But if it trades about 10 points lower (ETF down 25%), the option will probably trade from $9.50 down to about $3.70 (5.8 points). 

Again, that's up 8.5 when we are right, and down 5.8 when we are wrong by the same amount.

What about the oil and gas sector?  If DUG trades 3.75 points higher (ETF up about 25% because the oil sector declined by 12.5%) in three months, the option will probably advance from $4 to $7.40 (up 3.4 points).   But if it trades 3.75 points lower (ETF down 25%), the option will probably trade from $4 down to about $1.50 (down 2.5 points).

Again, that's up 3.4 points when we are right, and down 2.5 points when we are wrong by the same amount.

In both cases, when the ETF trades up 25% in three months, the option likely trades almost 85%-90% higher, and when the ETFs trade down 25% in three months, the option likely trades almost 65%-70% lower.

Unlike the options I'm telling you about, the stock or ETF trader loses or gains the same amount if the stock or ETF trades lower or higher by the same amount. 

Now, the options strategy will be much more volatile because it uses leverage.  I don't recommend over-leveraging yourself because ... what if we are wrong?  It happens. 

So, if you normally commit $10,000 to an idea, it might make more sense to commit closer to $2,500 - $5,000 to an options position.  We prefer the options strategy with the higher reward/risk ratio. 

Now, of course, anything can happen in the stock market.  We all know that already.  This may be a winner or a loser -- and of course, I'm highly confident it's a winner.  But either way, what we have just done is we have just dramatically reduced the risk of being wrong, and we have increased our odds of making money. 

* We aren't betting on any single stock, but a group of stocks (diversification = MUCH lower volatility risk).

* We aren't betting on the direction of the group of stocks (ETFs), but the relative performance (we are no longer relying on the general market direction to help with profits).

* We are betting on SECTORS (and sectors' trends tend to be much more stable and not erratic, so the trend intact tends to stay intact for quite a while).

* Using the options strategy, even if the tech ETF moves up by the same percentage that oil and gas moves down, we will almost certainly end up with a profit, instead of a wash.

The options I chose to use in this strategy are "the right" options.  In other words, not all options behave the same way. 

If you're interested in learning more about finding "the right" options for a strategy like this one, you might want to keep your eye out for the next time the Options GPS waiting list opens again.

Members of The Trend Rider will have exit alerts e-mailed to them, but you have to decide for yourself when to exit if you're not part of TTR.

What if the ETFs I mentioned are not at the same price by the time you read this?

I think this is a good trade as long as the ProShares UltraShort Oil & Gas (DUG) April 12 Calls (Symbol: DZG DL) is bought below $4.40, while the ProShares Ultra Technology (ROM) May 35 Calls (Symbol: ROM EG) is bought below $10.30.  There may be a large spread between the bid and ask, so I think it's best to enter limit orders with prices a bit below the asking prices. 

ENJOY!

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