Shorting China and Financials: Money Left on the Table - A Cautionary Tale

On Tuesday, I was stopped out of my position in the ProShares UltraShort FTSE/Xinhua China 25 ETF (FXP).

I managed to obtain an 18% gain on the trade in FXP but this is actually a pretty lousy result because there were other opportunities to sell at a much better price. Why didn't I? Because I ignored my rules for trading.

Trading is not like buying and holding for the long term. Nevertheless, both types of investing should be pursued with a set of rules, a discipline if you will, that guides your decisions. The rules may be different in these two cases but you should define your rules and stick with them. Unless, of course, they seem to get you into trouble on a regular basis in which case perhaps they should be revised.

First, let's talk a little about the rules I try to follow. They're pretty simple and not particularly original but they are what I use. Here they are:

Stops should be employed at all times. Support and resistance levels should be looked at in order to determine stops. Also look at trend lines and moving averages. Stops should be re-evaluated and updated as a stock moves up.

Stops must be really wide for Ultra ETFs.

Don't chase performance.

You must have an exit strategy when you initiate a trade. The exit strategy must always take into consideration what kind of gain is reasonable for a trade as opposed to a long-term buy-and-hold. Stops or trailing stops should be part of the exit strategy. Put some time into getting familiar with the stock's chart.

Avoid buying or selling in the first hour of trading. Sometimes, when economic data is released before the opening bell, this rule can be broken but only if you are confident the data will support one-way trading that day.

Look at over-bought and over-sold indicators (RSI, Bollinger Bands) when looking to time a trade. This goes back to the rule about not chasing performance. Be patient!

So what rules did I break with the FXP trade?

To begin with, I ignored my exit strategy. Since FXP is basically the double inverse of the iShares FTSE/Xinhua China 25 ETF (FXI), it seems reasonable to track FXI when trying to determine expected moves in FXP. In looking at FXI, I identified several support levels. I waited patiently for FXI to violate one more support level at around $140 and drop down to the next level below. I had decided that at that point, it would be time to sell FXP. As FXI began to move in the expected direction, I needed to answer some questions to validate my exit strategy: Was there a chance FXI would break down below this new lower support? Was my gain on the FXP trade at this point good enough? Would holding on for the next leg down in FXI be too risky and jeopardize my hard earned profits?

The correct answer would have been that current profits were good enough. FXI had already fallen over 30% from its peak and the easy money had been made on the short side. Accordingly, FXP had hit a new high and the profit on my trade, having opened the position at $86, would have been in the neighborhood of 30% to 35%. That was a reasonable gain. In order to preserve this gain, this would have been the time to tighten stops. Which leads me to the next rule that I broke.

It's true I had a wide stop in place but I had not re-evaluated it as FXP surged upward. When the markets began to bounce off their recent lows last week, FXP fell fast and hard. Now I was in a position where I was worried about preserving some kind of profit. This is when I was stopped out of the position.

So the moral of the story is that you must be willing to put in the effort to maintain a discipline or you should avoid trading for the short-term. As for myself, I hope I have learned a lesson from this experience.

Postscript: So Wednesday morning I saw an opportunity for a quick trade in the ProShares UltraShort Financials ETF (SKF). There were a number of news items that I knew would affect the financials: downgrades, estimates of further writedowns, slashed earnings estimates, the Clear Channel deal falling apart and the bad Durable Goods report. SKF had fallen right down to its trend line. I bought just after the open at $107. The ETF closed at $110.98.

So did I follow my own rules? The ETF was certainly not over-bought, so that was good. It looked like it couldn't be any lower and still be a buy. I did buy at the open instead of waiting but, given the news, it seemed the day's trade would go in a consistent down direction. My exit strategy is more conservative than it has been in the past with this ETF. Instead of expecting the ETF to rise to the $140 level again, I intend to tighten stops considerably as the ETF gets to the $120 level. We'll see how this plays out.

Comments

[kkin365]

Interesting presentation. It seems to me that using rules for trading in regular positions (long) for trading in short positions (such as SKF) requires two distinct mental sets, which I do not possess. Where could one find out the portfolio of SKF? I got a prospectus from the sponsor but there is nothing specific.

[TradeRadarOperator]

The portfolios of the Ultra Short ETFs are somewhat incomprehensible for non-professional investors, consisting as they do of swaps, options, etc. That is why I often look at the regular, unleveraged corresponding ETF for signals. FXI, for example, has a set of underlying stocks as does XLF, which is the ETF I track as a kind of mirror-image of SKF.

[venividivici]

The world's financial markets have degenerated into nothing more than a casino and that's why we have this dreadful mess. Have you guys ever thought of playing roulette? Your chances of winning are just under 50%.

[HedgeTruth]

this author is an idiot of the highest order...ok..1 last time with regard to ETFs...charts mean nothing...

the skf has 293 stocks in the index...so chart patterns mean nothing...

don't you people understand this...there is no chart support or resistance with an etf...because it could be any number of millions of combos of different stock movements of the underlying 293 companies...

does the lemming idiot crowd finally get this...?...

how could someone be so stupid as to NOT understand this...

[loben]

HeadTooth - Why be so anal? The Dow has support, the NASDAWG has support, why can't the SKF have support? If enough people buying it think that it does, then it becomes a support.

[User 168446]

Yeah know it all Hedgie I guess all the traders in the S&P pits are idiots too. Let's see if you can guess this one right. How many stocks are in the S&P 500?

[Nu2theGame]

TRO, thanks for these pointers. As name suggests I'm a new trader. I got clobbered in SKF last week. Made bad decisions and all wrong moves. Sat out this week because didn't know what EOQ would mean (should have figured managers would want financials off their lists), but I want to play again, hopefully smarter. What do you think of moving between UYG and SKF? Please share any more insights. Thanks again.

[Ex15:26]

While HedgeTruth is correct, intraday, these things do trade directionally in the same direction as the market basket of financials. However, his statements would have us believe that there is some linkage during the middle of the day between the workings of 293 different firms and this ETF in some technical way. If that were the case, ETFs like SLV would trade exactly in lock step percentage moves with the underlying commodity they are trying to represent. Clearly that is not the case and the difference is a result of several things.... and one of them is the supply and demand of folks that want to by these things.

I think it is a good exercise to examine the chart on SKF to see where you think support might be, but I wouldn't use it the same way I would for a stand alone equity, because everything is really story driven and you are basically take a stab at where you think financials will go and then holding on.

Use stops!
Blessings.

[User 168446]

Ok Jesus Freak! Can you guess how many stocks are in the S&P 500?

[Almsforthepoor]

Hey HedgeTruth

I don't invest based on charting at all. I don't think it's reliable. However, a very good argument could be made that if securities follow some sort of pattern (as shown in a chart), then a chart of an index (fund) may be a more reliable indicator than the chart of a single stock. I understand your logic. But, really, the converse may be true. I'd like to see some numbers...