S&P 500 Finishes Strong; Higher Prices Expected

Written by Stock Option Coach

On February 26, 2017
SPY Stock Chart - February 26 2017

Market Overview

The QQQ’s (Nasdaq) tried to start some kind of a correction only to see the big buyers come back in at even the hint of a bargain! I could give you all kinds of reasons why this happened after the fact, but then I would be doing what the media does. And to be honest, I don’t care why it happened. I lost the need to have reasons for the market’s behavior a long, long time ago. Why? Because I discovered that the price action of the market (aka technical analysis) and the leading stocks were all I needed to know the odds and probabilities. 

When you play 5 card draw poker, do you like to bet when you have three Aces? I do, and I play the market the same way. Because if I’m betting aggressively with a pair of fours, I am going to be scalped by the pros. Same for the market. Don’t feed the pros your money! Follow what the market is telling you. And the market is telling us that it expects President Trump to do the kind of things that will benefit the market.

He says he will cut taxes, reduce regulations, and spend money on infrastructure projects. The market is not an after the fact kind of beast. It leads and anticipates with the big money moving the market. And the big money is happy with their holdings and not selling. Too simple of an explanation?

Those who know me or were taught how to trade by me, know I don’t care for long-winded, ego-driven, predictions or BS. I’m a simple man who can accept a method that works. When an index like the QQQ’s start running up the 10 dma, I just accept it and get on board. And as an options trader, you won’t find a better bid/ask.

Stocks & Trade Ideas

In simple terms, the Dow has been up 11 out of 11 of the last trading days. Impressive! Nasdaq has been up 10 of the last 13 days! SP-500 has been up 14 of 17 days! Forget IWM as it’s been the laggard. But what I want you to notice is that the big institutional glamour stocks have been on the move. The small caps not so much but they are normally strongest in the early stages of a bull market. And they did lead the way after the election by going up 18 of 24 days.

I told my students last July 2016 that we had broken out of the 2-year trading range, and to expect big things to happen now that we were headed back into a trending market again. So if you stop and think about how strong the stats are at the beginning of this paragraph, doesn’t that tell us that this market should head higher. Doesn’t mean we can’t have a correction because we will eventually, but I will be taking all the long setups until we do.

Another thing I would like to point out is that lots of traders are taking a fresh look at the big cap stocks. I trade them exclusively because they make big moves and I can use options as leverage (I also trade the indexes).In fact, that is the only reason I trade options! If you are trading a $30 stock and if moves 10% this week. It will move $3. If Amazon makes a 10% move this week, it will move $84. Who do you think will make the most money if they are using options? Amazon was my most traded stock last year and produced the most profits.

Trade what you will but in a trending market, the big cap stocks are going to receive a lot of the institutional money. And the hedge fund guys control over $3 Trillion that they can invest. And they are. Look at the volume in the big stocks. Who can afford to buy the stock of Priceline? 100 shares of PCLN will cost you over $160K if you buy the stock. But this kind of high dollar stock is the playground of the hedge funds and the big banks.

Let’s take a quick look at the SP-500. I don’t buy break-outs, so I will not be chasing it, but I will be looking for a re-test of the current resistance line which may turn into a support line.

Quick note: SOC traders had a patented setup Friday morning, giving them a chance to get in early if this index gets moving again.

Tesla (TSLA) got hit with a 13% correction mid week but the bulls got back in as it neared the $250 range. The huge volume when the selling hit, shows us that this washed out the weak hands or retail traders, and the institutions stepped in to get a bargain. It seems very possible that this stock will need some time to consolidate, but after that huge three month run, you never know.

Netflix (NFLX) has shown that the institutions, who own 90% of the outstanding stock last time I checked, do not seem to be in the selling mood. Volume is decreasing without big selling, telling us that higher prices this week are very-possible if the market heads higher.

Amazon (AMZN) got whacked all the way back to the support line that goes back to late January but reversed after bulls decided it was a bargain at this price.

Apple (AAPL) continues to defy the pundits who wrote it off months ago when the iPhone sales dropped for the 1st time in its history. Once again, predictions steered you down the wrong path when all you had to do is follow price and volume.

Facebook (FB) found buying on the 10 dma as it has since the beginning of January. I actually bought it when it bounced off the bottom of the pennant pattern. The only pattern that I pay any attention to. Call it a wedge, pennant, bull flag, I don’t care as it has repeatability. And that is what I need to trade successfully.

Walt Disney Co (DIS) has found support at $109 where it also did two weeks ago on the 21 dma. The DVP pattern tells me that we could go higher this week if the overall market is up.

Trading Psychology

Stanley Druckenmiller

The “greatest money-making machine in history”, a man with “Jim Roger’s analytical ability, George Soros’ trading ability, and the stomach of a riverboat gambler” is how fund manager Scott Bessent describes Stanley Druckenmiller.That’s high praise, but if you look at Druckenmiller’s track record, you’ll find it’s well deserved.

Druck averaged over 30% returns the last three decades — impressive. But what’s even more astonishing is the lack of volatility… the guy almost never loses. He never had a single down year and only had five losing quarters out of 120 altogether! That’s absolutely unheard of. And he did all of this in size.

At his peak, Druck was running more than $20 billion and he was still managing to knock it out the park. When you study Druckenmiller you get the sense that he was built in a laboratory, deep in a jungle somewhere, where he was put together piece by piece to create the perfect trader.

Every character trait that makes up a good speculator, Druck possesses in spades… things like: Mental flexibility Independent thinking Extreme competitiveness Tireless inquisitiveness Deep self-awareness Maybe he’s a freak of nature or perhaps a secret Jesse Livermore / George Soros lovechild… or maybe he’s just a relentlessly determined trader who’s been on a lifelong path of mastery.

Either way, it behooves us to study the thoughts and actions of one of the game’s greatest. And with that, let’s begin.

On what moves stocks

In Jack Schwager’s book The New Market Wizards, Druckenmiller said this in response to the question of how he evaluates stocks (emphasis is mine): When I first started out, I did very thorough papers covering every aspect of a stock or industry. Before I could make the presentation to the stock selection committee, I first had to submit the paper to the research director.

I particularly remember the time I gave him my paper on the banking industry. I felt very proud of my work. However, he read through it and said, “This is useless. What makes the stock go up and down?” That comment acted as a spur. Thereafter, I focused my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals.

Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down. The financial world is chock full of noise and nonsense. It’s filled with smart people who don’t know a damn thing about how the world really works.

The financial system’s incentive structure is set up so that as long as analysts sound smart and pretend like they know why stock xyz is going up, they get rewarded. This holds true for all the talking heads and “experts” except for those who actually trade real money. They either learn the game or get competed out.

Being one of those who compete in the arena, Druckenmiller was forced to learn early on what actually drives prices. This is what he found:

Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures.

It’s liquidity that moves markets. Liquidity is the expansion and contraction of money, specifically credit. It’s the biggest variable that drives demand in an economy. It’s something our team at Macro Ops follows closely. The federal reserve has the biggest lever on liquidity. This is why a trader needs to keep a constant eye on what the Fed is doing. This is not to say that things like sales and earning don’t matter. They are still very important at the singular stock level.

Here’s Druckenmiller again (emphasis mine): Very often the key factor is related to earnings. This is particularly true of the bank stocks. Chemical stocks, however, behave quite differently. In this industry, the key factor seems to be capacity. The ideal time to buy the chemical stocks is after a lot of capacity has left the industry and there’s a catalyst that you believe will trigger an increase in demand.

Conversely, the ideal time to sell these stocks is when there are lots of announcements for new plants, not when the earnings turn down. The reason for this behavioral pattern is that expansion plans mean that earnings will go down in two to three years, and the stock market tends to anticipate such developments. The market is a future discounting machine; meaning earnings matter for a stock, but more so in the future than in the past.

Most market participants take recent earnings and just extrapolate them into the future. They fail to really look at the mechanism that drives the bottom line for a particular company or sector. The key to being a good trader is to identify the factor(s) that will drive earnings going forward, not what drove them in the past.

Druckenmiller said in a recent interview that his “job for 30 years was to anticipate changes in the economic trends that were not expected by others, and, therefore not yet reflected in security prices.” Focus on the future, not the past. Another thing tht sets Druck apart is his willingness to use anything that works; as in any style or tool to find good trades and manage them. Another discipline I learned that helped me determine whether a stock would go up or down is technical analysis.

Drelles was very technically oriented, and I was probably more receptive to technical analysis than anyone else in the department. Even though Drelles was the boss, a lot of people thought he was a kook because of all the chart books he kept. However, I found that technical analysis could be very effective. I never use valuation to time the market. I use liquidity considerations and technical analysis for timing. Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.

Druckenmiller employs a confluence of approaches (fundamental, macro, technical and sentiment) to broaden his view of the battlefield. This is a practice we follow at Macro Ops. It doesn’t make sense to pigeonhole yourself into a single rigid scope of analysis… simply use what works and discard what doesn’t.

How to make outsized returns

Druckenmiller throws conventional wisdom out the window. Instead of placing a lot of small diversified bets, he practices what we call the “Big Bet” philosophy, which consists of deploying a few large concentrated bets.

Here’s Druckenmiller on using the big bet philosophy (emphasis mine):

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets.

They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

A lot of wisdom in that paragraph. To earn superior long-term returns you have to be willing to bet big when your conviction is high. And the corollary is that you need to protect your capital by not wasting it on a “bunch of stuff” you don’t have much conviction on. This reminds me of what Seth Klarman wrote in his book Margin of Safety: Avoiding loss should be the primary goal of every investor.

This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of capital. While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators.

The speculative urge that lies within most of us is strong; the prospect of free lunch can be compelling, especially when others have already seemingly partaken.

It can be hard to concentrate on losses when others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome. You need to keep your powder dry so that when the stars align you can go for the jugular and turkey neck that son of a gun.

The importance of striking when the iron is hot is something Druckenmiller learned while trading for George Soros. I’ve learned many things from [George Soros], but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity. An intense focus on capital preservation coupled with a big bet approach is the barbell philosophy used by many of the greats. Keeping your losses small and pushing your winners hard is the name of the game in profitable speculation.

The fund washout we’re seeing today is not just because of the glut of mediocrity in the money management space, but also because even decent managers are scared to take the necessary risks to have big return years. They manage too much to the benchmark and are too short-term focused. That’s a recipe for average performance.

Here’s Druck on how it should be done:

Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the conviction, go for a 100 percent year.

If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns. Once you’ve earned the right to be aggressive and can bet with the house’s money (profits), you should plunge hard when that high conviction trade arises and push for outsized returns.

The trader’s mindset and handling losses

According to Druck, to be a winning trader you need to be “decisive, open-minded, flexible and competitive”.

The day before the crash in 1987, Druckenmiller switched from net short to 130% long because he thought the selloff was done. He saw the market bumping up against significant support. But through the course of the day he realized that he made a terrible mistake. The next day he flipped his book and got short the market and actually made money. You see this type of mental flexibility in all the greatest traders.

And Druckenmiller is one trader that epitomizes it perhaps better than anybody else. The practice of having “strong opinions, weakly held” is difficult but paramount to success. In order to attain that level of mental flexibility, you need to learn to detach ego from your immediate trade outcomes. If you allow losses to affect your judgement, you’ll inevitably make bigger mistakes.

Druckenmiller learned this lesson early on from Soros. Soros is the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you. One of the best parts about this game is that as long as you stay alive (protect your capital) you can always make another trade.

Druckenmiller said the “wonderful thing about our business is that it’s liquid, and you can wipe the slate clean on any day. As long as I’m in control of the situation — that is, as long as I can cover my positions — there’s no reason to be nervous.”

I remember watching Charlie Rose interview Druckenmiller a few years ago. Charlie asked him why, after all these years, and with all the money he’s made, does he still put in 60-hour weeks trading? Druck responded (and I’m paraphrasing here) “because I have to… I love the game and I love winning, the money isn’t even important.”

To get to Druck’s level, you have to trade because that’s just what you do. It’s what you live for.

In closing, my Short term “Herd” is on a buy signal, and the Long-term “Herd” is overbought but it’s been that way since Feb 9th so I will still take all the long setups until I have a reason not to. And while most stocks are at overbought levels, I really hate to even use that term in a strong bull leg of a trending market as most hot stocks will go into this condition for quite a while, leaving you out in the cold if you don’t find a way to get on board.

Based on the SP-500’s big move up right at the close on Friday, the odds favor higher prices this Monday. And it is not unrealistic to expect a higher close this coming week in the market. If that changes, and your stocks start hitting your stops, just stand aside and keep your powder dry. The bull will be around for quite a while.

All the best,


Randall Hudgens

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