Wednesday, August 8, 2007

Income Trusts – NAL Oil and Gas – Part II

Warning: Buying a security in a long term downtrend is quite different than buying in an uptrend. NAL Oil and Gas is in a downtrend and therefore the probabilities that the trade fails are higher. Readers beware.

The Plan

As you know by now, I believe in having a plan for every stock I intend to own. The creation of such a plan starts with a Point and Figure chart analysis. That allows me to forecast a target price objective, evaluate when I will be wrong, and thus estimate a risk reward ratio.

NAL is clearly in a long term downtrend as shown by the red downtrend line. In April 2007, it reversed into a column of X establishing a support at $11.00 and a short term uptrend line (purple 45 degree angle line). It traded up to $13.50 and then backed down to the current price of $13.00.

From here, the price objective is a return to the downtrend line at $16.00 and it needs three resistance breakouts to get there (horizontal orange lines). The risk is a break of support at $11.00 to the red square of $10.50.

If this evaluation is correct, we have a return of $16.00 - $13.00 = $3.00 on a risk of $13.00 - $10.50 = $2.50 or a ratio of 1.2 to 1.



On the surface, the return to risk ratio does not appear that great, especially given that I require a minimum of 2 for 1 and prefer a ratio in the 3 to 1. I will address this problem when I discuss the trading tactics later on. But first, I want to evaluate the “fundamentals” of the company.

For this I use a long term monthly chart of all the securities that I follow. I believe that the long term trend line of prices is a good approximation of a companies’ growth rate over the cycle. Above this trend line I draw a parallel trend line in order to create a channel where most market prices should trade. There are times when a stock gets overvalued (see the over valued zone in red) and times when it comes back to the growth line (we are there now). My $16 price target appears conservative as it is within the expected trading band.



Finally, I also use the Fibonacci tool to evaluate the critical support level following any major correction (purple oval = $12.18).

The second factor that I consider important is that a stock must have a relative performance better than that of the market. In order to evaluate that, I also use a P and F chart of the stock divided by the TSX index. The number therefore means absolutely nothing. There are two things that one must monitor with relative strength:


-1- Is the relative strength in a column of O or a column of X. NAE.TO = X
-2- What was the last event a breakdown or breakout? NAE.TO = Breakout

NAL Oil and Gas is therefore one of the rare income trust that I follow with a Breakout in a column of X.

The Trade

Converting a longer term plan into a trade becomes somewhat of an art and it always requires the identification of a stop loss if you are wrong in your assessment of the trade.

The art part is a function of the tools you use. It can be a screening system or a set of indicators which you monitor in order to time the trade to the best of your ability. I personally use the combination of an oscillator, volume indicator, and a non conventional convergence divergence indicator on different time frames as a confirmation for a trade.

In order to determine the right stop loss, I use a P and F chart with a 25 cents box size which I feel is more appropriate to the shorter term horizon of a trade. The chart below looks at NAL from that perspective.

Notice that the price column now increases by $0.25. Notice also that the resistance and support levels are different. Buying at $13.00 puts me in the middle of a trading range limited by support at $12.50 (green horizontal line) and resistance at $13.50 (purple horizontal line). The logical stop loss point on this trade is just below support at $12.25 (orange square).

So we now have a return of $16.00 - $13.00 = $3.00 on a risk of $13.00 - $12.25 = $0.75 or a ratio of 4 to 1.

If I hold this stock for one year, I will get a 14%+ return as income plus any variation from the price of the security in the marketplace.

An investor might evaluate his risk differently by evaluating the 0% return price which on this trade is around $11.00. That’s the price where, for the year, the total return would be $0 ( Price – Dividend or $13.00 - $1.92).

The Word
Therealword@gmail.com

Disclaimer

The information presented on this site is for educational and entertainment purposes only. This site contains no suggestions or instructions that you must follow, do your own research and due diligence before committing your cash to the markets. Your on your own.