Securities Research Services

Friday, January 25, 2008

A Lesson in Probabilities

We've said it many times before and we will probably say it many times more, making money in the market is all about putting the probabilities in your favor. It could also then be said that you should only trade when the probabilities are favorable.

In other words, there are some markets where probabilities are so low that it is almost guaranteed you will lose money. During these times, cash should be your number one position.

How the Probabilities Stack Up Here

Before we look at the current charts we should probably explain what a situation with favorable probabilities looks like. There are many possibilities, but for the ease of explanation, we will examine a couple of high probability trading situations:

When the market trend is up and prices have pulled back to support on lower relative volume and technical indicators indicate a general near term oversold condition; probabilities are fairly good that you will see higher prices ahead. During these times it pays to look for good long set ups.

Vice versa, when the market trend is down and prices have pulled up to resistance on decreasing relative volume and technical indicators indicate a general near term overbought condition; probabilities are fairly good that you will see lower prices ahead. During these times it pays to look for good short set ups.

A Low Probability Example

On the other hand, if the trend is up and prices are in the middle of a pull back it just doesn't pay to try and pick a bottom where the pullback might exhaust itself. Pull backs are strange animals and they have a mind of their own. No one can see the future and no one knows when and where the pullback will end and prices will once again reverse in the direction of the trend. Trying to guess is nothing more than gambling. This is the environment that chews up trading accounts.

Likewise, if the market is in a downtrend, and is pulling back, you can guess where it might run into resistance, but until it stops and reverses and until the technical indicators flip back to overbought you are going to get chewed up trying to short.

Even worse, since surprises occur in the direction of the trend, you are taking a huge risk if you decide to actually buy against the broader trend.

This is Where We Are Now

We are right in the middle of a low probability environment. The market is in a downtrend; and a strong one at that. Yet prices are pulling back up to resistance. At some point there will be a tradable bounce in the downtrend, but at this point probabilities are very low for opening new short positions as we will show in the S&P chart below, and they are even lower if you choose to step in against the trend and start buying hoping that overhead resistance breaks.

Let's Take a Look at the Charts

As you can see from the SPY (S&P 500 ETF) chart below, the 10-, 20-, and 50-day averages are all in a steep decline (blue, green, and brown lines). This is a clear downtrend.

Also note that volume was heavy on the decline, but as of yesterday volume declined significantly from the previous day. This is typical of a pullback in the primary trend.

So far, so good. We have a downtrend, all major moving averages are confirming, price is in steep decline with heavy volume to the downside and decreasing volume to the upside. All the right conditions for shorting.

However, conditions are not yet right for entering new short positions.

Why? The pullback is still in tact. We can see several layers of overhead resistance including August lows and the declining 20-day average fast approaching price. Yet, until the pullback runs its course (making a lower high by closing below the previous day's low) and the stochastics indicator turns back down over eager short traders are bound to feel some pain.

We are already seeing this. Microsoft reported better than expected earnings and the market was gapping up in after hours trading last evening. We want to emphasize THE RESPONSE TO MICROSOFT IS NOT A BUY SIGNAL (unless you are perhaps a day trader).

What we are faced with today is a market that has the potential to gap up into some areas of major resistance. We are near, it looks like, a turning point where it will pay to reload short positions. But, probabilities are not quite ideal yet. We are close, but until we get there, remember, cash is a position to.

Don't be so eager to put your money to work when all systems are not quite in alignment yet.

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