Thursday, August 2, 2007

Knowing when you are wrong.

A few days ago, I read a piece by a fellow blogger who is extremely bullish on silver. When you read his arguments, he is very convincing and he makes a lot of sense. However, at the end he writes:

To me it is just mind boggling how cheap silver is right now and nobody can seem to see it. Well I for one see it. I don’t give a damn if silver drops $2-3 tomorrow. All that means is it’s more of a bargain.”

That brings me back 20 years ago when I listened to this kind of discourse from many Value Managers. These days, value managers are smarter than they were then. These days, they realize that “reversion to the mean” is not immediate. A cheap commodity or stock can get a lot cheaper before its real value is arbitraged by the market. Actually, this is the greatest risk of a value manager. Buying too soon. If something is really cheap and its fundamentals strong, and you buy too early, fortunately time will be the manager’s friend. Eventually, the security will get re-evaluated upwards. But I’m digressing.

I wonder if this blogger has a plan. Does he really listen to what the market has to say? Does he realize that should silver drop $2-3, the game will have totally changed? Having a plan means that for every position that you take, you know when you will be wrong and you know when you will be right. If you don’t do that exercise for every stock you trade, whatever your investment timeframe, you are a fool and over time the market will punish you.

Point and Figure charts allow you to design a plan. You know in which playing field (price zone) you will play and you know when your strategy will succeed or fail. Let’s look at silver:

-1- Silver is in an uptrend as shown by the dark green line sloping at a 45 degree angle.
-2- Three times it rebounded from a price of $12.50, a triple bottom formation which is clearly a strong support zone (green horizontal line)
-3 – However, the last “O” at $12.50 happens to be right on the long term uptrend line, making this support zone even more formidable.

What could go wrong?
Should the price drop to $12.00, it will have violated triple support AND the long term uptrend line and we will be officially in a bear trend (red square). Given the significance of the support zone configuration, the message would be terrible. It would be time to short.

What can go right?
The price needs to breakout from three resistances starting at $14.50 all the way up to $15.50 (green rectangle) and then watch out above for blue sky.
Are you starting to like P&F as a tool to quantify your intuitions?

I present below the traditional chart equivalent for silver. I wonder if you would have made the same analysis. The key support and resistance zones have been identified in green and red. I also show in the lower panel one of my favorite indicators called relative strength. A short discussion of this concept follows:

The name of the game is to outperform the market. If all you want or need is to perform as well as the market, then just buy an index fund or an ETF that mimics the market. XIU.TO is a good candidate for that. In this example, relative strength compares the price movement of silver to the TSX index. When the slope of that ratio (line) is up, silver is doing better than the market, and I probably want to own it (blue line). When the slope is down (red line), silver is under performing the market. When that’s the case, why own it?

Here is a word of caution. You always have to be aware of what the market has been doing when you look at relative strength because you want to own outperforming stocks in an up market. In a down market swing like that of the present, the stock might be out performing the market but in absolute terms, you are losing money, just less money than if you were invested in the market.

In conclusion, I want to stress how important it is for you to have a plan. In my previous posts, I had a plan. For every situation I presented, I identified not only the potential profit (the reward) but also the exit point should I be wrong (the risk). Suffice to say that I use P&F because although it is very difficult to forecast anything, history has proven that your chances of success are higher if your forecast over a longer time frame. P&F is the perfect tool for that. Trading then just becomes a shorter term implementation of that plan.

The Word

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