Buy the Strength Well the Weakness

The first half or this decade has witnessed some of the toughest and most frustrating financial markets in recent memory. Good trading strategy holds that you should be able to profit equally in both up and down markets. But, during many campaigns, markets have appeared to be moving both up and down nearly simultaneously. Many solid uptrends have been punctuated with violent downside reactions. These price slides briefly halt the uptrend by stopping out speculative long positions and after the stops have been 'cleaned out,' the market resumes its northerly course. Conversely, quite a few bear trends have experienced equally violent tallies. The rally cleans out the speculative protective buy stops, knocking the so called weak holders out of their profitable short positions; then the bear market resumes. 

The attention of the margin department is being noticed more frequently than ever before due to the erratic and violent nature of counter trend swings. What should you do when confronted with the ever familiar call for additional margin? Over the many years, I have had countless conversations with traders, both in stocks and futures, concerning the strategy of dealing with margin calls. In general, most investors are ambivalent and inconsistent in their response to margin calls and require guidance in terms of a viable, strategic response. There are two types of calls: new business and maintenance. Exchange regulations generally require that new business calls be met with the deposit of new funds, not by liquidation. Maintenance calls, however, can be met with either deposit of new funds or by reducing positions. 

Maintenance calls are the most common type of margin call and it is unfortunate that most investors invariably make the wrong decision when confronted with the request for additional margin. There are two options: putting up new money, or reducing positions. If reducing positions, a decision on which one(s) should be liquidated to meet the call should be made. In most circumstances I do not recommend depositing new funds to meet a maintenance call. The call is a clear sign that the account is underperforming, or at least some of the positions are underperforming, and there is no logic in trying to defend bad positions with fresh money. The appropriate strategy is to liquidate some positions to eliminate the margin call and to reduce your risk exposure. But, if you close positions to reduce risk, aren't you also reducing your profit potential and your ability to regain a profitable footing? Reducing positions, yet maintaining and even enhancing your profit potential sounds like a worthwhile although hypothetical goal; but how can you actually achieve it? It can be done with a simple and basic strategy that is well known to successful professional traders but unfortunately, not to public speculators. Those positions Which show the biggest paper losses when marked to the market, should be closed out especially if they are moving anti trend. This clearly reduces risk exposure. Yet, by maintaining the most profitable positions, which are trending in the direction of the dominant market trend and possibly even adding to those positions (pyramiding), you are maintaining your potential for profit. The odds clearly favour ultimate investment success on profitable with the-trend positions over losing anti trend positions. 

Regrettably, most speculators choose to close out their profitable positions while holding on to the losing ones. How many times have we heard the statement, 'I can't afford to take the loss.' The likely outcome of this attitude is that, when the position is ultimately liquidated, the loss is greater than it would have been earlier in the game. The strategy of closing profitable positions while holding on to losing ones is costly and is typical of unsuccessful traders. Conversely, one of the traits of successful operators is to close out losing positions and stay with, and even add to, the winning ones. And, while it may be more gratifying to take profits rather than losses, we should not be concerned with satisfying the ego here. We should be playing for big profits coupled with limited risks and, in that context, you should be more concerned with an overall profitable operation than in trying to prove yourself right and the market wrong. 

There is another corollary here that professional operators use. In any given market, or in two related markets, you should buy the strongest acting one and sell the weakest acting one. This tends to hedge your bet in a constructive fashion, because-«if the market advances, your long leg should outperform your short leg; while, if the market declines, your short leg, being the weaker acting of the two, should go down faster and further. And, in some markets, futures for example, you may get an accompanying bonus, with reduced straddle (spread) margins. 

The strategy of buying the strength; selling the weakness can be exemplified by the Chicago com market which was in a broad downtrend from late 1983 to early 1987. The wheat market, on the other hand, was trending generally higher, providing technical, or systems traders, with a succession of highly reliable and straightforward trading signals. Let us assume you received a sell signal in com during June 1986 and put on a short position. Your margin in each 5,000 bushels com contract would have been US$400. Then you received a buy signal in wheat in October of the same year and bought a contract. The margin on each wheat contract would have been US$600, so for your combined short com and long wheat position you would expect to have to post US$ 1,000 in margin. You may be surprised to learn that you wouldn't have to post this amount or even US$600, the higher of the two legs. It is possible to put on the entire two sided position (short com and long wheat) for a total margin of just US$500. Generally however, it is not advisable to trade on such a thin margin and in this example, at least the US$600 required on the higher side (wheat) should be deposited, but it's still very high gearing. Refer to Figures 12. l , 12.2 and 12.5 to see how the position worked out. Note the high profit, due to the extreme gearing involved, that was earned during this period in the com versus wheat spread position a result of buying the strength and selling the weakness. 

Figure 12.1 July 1987 Com. You buy the strength (wheat) and sell the weakness (com). This is the type of situation that many professional operators seek; it has good profit potential, reasonable risk, and low margin. Opportunities like this appear every yeat-and the trader should be alert to the chance to buy the strength and sell the weakness. For entry timing, you can take signals from whichever technical or trading system you have confidence in and time each leg on the basis of these signals. 

Another aspect to this buy strength and sell weakness strategy is a tendency of many futures bull markets to experience a so called price inversion, also called an inverted market, in which nearby futures gain in price relative to the distant months of the same commodity, and ultimately sell at premiums to the distant markets. This could be due to a tightness, or to a perceived tightness, in spot (nearby) supplies. Traders should watch these spread differences carefully, because an inversion of the normal relationship between nearby and distant futures (on a closing price basis) could help confirm a bull market. In fact. I generally add an additional 25% to 50% to any long position I am carrying following such a price inversion. 

Figure 12.2 july 1987 Wheat. You buy the strength (wheat) and sell the weakness (com). This is the type of situation that many professional operators seek; it has good profit potential, reasonable risk, and low margin. Opportunities like this appear every year-and the trader should be alert to the chance to buy the strength and sell the weakness. For entry timing, you can take signals from whichever technical or trading system you have confidence in and time each leg on the basis of these signals. 

  should be deposited, but it's still very high gearing. Refer to Figures 12.1, 12.2 and 12.3 to see how the position worked out. Note the high profit, due to the extreme gearing involved, that was earned during this period in the com versus wheat spread position a result of buying the strength and selling the weakness  

Figure 12.3 july 1987 Wheat versus Com Spread Chart. As an alternative method of timing spread (buy strength versus sell weakness) trades, you ran use spread charts, These charts are available for a broad selection of related markets or two different futures in the same market. You can enter and liquidate positions on the basis of price differences. As an example, let's assume you put on long wheat versus short com at wheat 70 cents over com, and the current difference has widened to 1.00 over (you have a 30 cent profit on the position). If you want to stop out if the difference narrowed to, say 90 cents, you would enter the following order. "Buy (quantity) com and sell (quantity) wheat at 90 cents stop, premium on the wheat." With this order, you would be locking in your profit at 20 Cents, less breakage and commissions. 

One other aspect of these so called spreads, particularly iti'._currency or futures markets, is a tendency among some traders to straddle up to avoid taking a loss.'Assume for example, you ate long silver with a big loss on the position, and the market is trending down. Rather than take the loss by selling the May silver, some traders would sell July silver instead, effectively locking in the loss at that point. This is not a good idea. This act doesn't prevent the loss; it merely postpones it and the losing position still has to be dealt with in unwinding one of the 'legs' of the spread. A more logical strategy is to take the loss, by closing out the original position; then watch the market from an unbiased, sidelines position and re enter either long or short when the trading indicators provide an objective entry signal. 

In summary, it doesn't much matter how you label the basic strategy: hold the profitable position and close out the losing position, or buy the strength and sell the weakness. What is important is that you are aware of it, identify the strong versus weak markets and apply this strategy consistent and disciplined manner.