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Simple Rules Rarely Work Well in the Stock Market

Simple Rules Rarely Work Well in the Stock Market

Sometimes, investors notice something interesting and believe it can be a trading signal. The headline indicator is an example of this. This indicator tells us to expect a reversal when a story reaches the headlines.

This is a logical rule in many ways. The idea behind the headline indicator is that reporters are always chasing news. By the time they get to the story, the stock market will already be factoring the story into the stock price.

In this way, the headline indicator is a contrary indicator. This type of indicator assumes that making money in the stock market is difficult to do. That part of the underlying logic is correct. But, the error comes in the next assumption.

Since making money in the markets is difficult, contrarians believe that widely held beliefs will be wrong. So, the crowd will be bullish at market tops and bearish at market bottoms. When everyone believes something, the trend is set to reverse.

In the case of the media, contrarians assume that when stories are in the news, there is no way to make money from the idea. The idea would need to be obvious in order for the reporter to consider it to be news and the market is forward looking. Therefore, news headlines can’t lead to profits.

The Problem With Contrarian Indicators

Investors tend to look for information that confirms their biases. With the news, there are a few classic examples that demonstrate the contrarian approach works. There was a Newsweek cover near an important bottom in 1974.

Simple Rules Rarely Work Well in the Stock Market

There was also a BusinessWeek cover in 1979 that analysts often point to. The magazine proclaimed the “Death of Equities” as equities were set to begin an extraordinary bull market that would run for most of the next two decades.

Simple Rules Rarely Work Well in the Stock Market

While these examples provide proof to contrarians, the contrarians are missing a major point. There are many stories about the market that prove to be right. This is because contrarian approaches are built on a major flaw.

Contrarians believe the majority of investors will often be wrong. In fact, the majority will be wrong at major turning points in the market. But, the majority will be right in the extended price moves that lead to major reversals.

A bull market, for example, requires buyers. When the majority of investors are buying, prices are rising. Eventually, the underlying fundamentals change and the trend will reverse. At that point, most investors will be unlikely to spot the change in fundamentals. They will be caught unaware of the reversal.

But, this is true only at turning points. Turning points are visible with 100% accuracy only in hindsight. The truth is that most of the time, the crowd will be right about their opinion. This means headlines will be right more often than not and the news can be a valuable source of information for traders.

The News for Airlines is Bearish

In looking at the news, a consistent theme on airlines is emerging. The industry is once again at a crossroads.

After decades of losses, the industry enjoyed a few years of large profits. Now, expenses are rising, a turn of events that is not entirely unexpected. This should make it more difficult for airlines to make money even though the problems are widely recognized.

In a prominent story on its home page, Bloomberg noted, The Fat Years for U.S. Airlines Are Coming to an End. The article provided a number of good reasons to believe the operating environment for the industry has changed.

The article explained, “While summertime profits were fine, and travel demand remains robust, a number of airlines are facing higher bills from a variety of factors: labor contracts, significant airport renovation projects, technology spending, and fleet upgrades.”

This is natural given the ups and downs of the industry and the reason the industry delivered profits in the last few years. To keep their jobs, many employee unions agreed to concessions that boosted the airline’s ability to generate profits.

“In an industry that took so much away from its employees … of course once they were earning billions of dollars in net profits again they were going to have to give some of that back,” said Seth Kaplan, managing director of trade journal Airline Weekly.

Trading the Decline

In a strong market, the best trade is usually in the strongest stock. In a downturn, the same is true in reverse. The best trade is often in the weakest stock. For airlines, the weakest stock at this time is United Continental Holdings, Inc. (NYSE: UAL), a stock that sold off last week on weak earnings.

Simple Rules Rarely Work Well in the Stock Market

To benefit from weakness, an investor could buy put options. But, as the chart shows, MO has been in a downtrend and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.

But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.

The risk profile of this trading strategy is summarized in the diagram below.

Simple Rules Rarely Work Well in the Stock Market

Source: The Options Industry Council

The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.

The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.

A Bear Call Spread in UAL

For UAL, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly.

In this case, we could sell a November 17 $61 call for about $1.15 and buy a November 17 $62.50 call for about $0.65. This trade generates a credit of $0.50, which is the difference in the amount of premium for the call that is sold and the call. Since each contract covers 100 shares, opening this position results in immediate income of $50.

The credit received when the trade is opened, $50 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $100. The risk is found by subtracting the difference in the strike prices ($1.50 or $1.50 time 100 since each contract covers 100 shares) and then subtracting the premium received ($50).

This trade offers a return of about 50% for a holding period that is less than three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if UAL is below $61 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $100 for this trade in UAL.

You can find more trades like this in the TradingTips.com service, Options Cash Cow. To learn more, click here.