A Strategy for Bargain Hunters Following a 114-Year-Old Buy Signal

Charles Dow passed away in 1902, but his insights into market behavior hold up well 114 years later. Dow was among the first to realize that market action and economic growth were highly correlated. He created the Dow Jones Transportation Average (DJTA) to forecast the economy. Later, he created the Dow Jones Industrial Average (DJIA), which remains one of the most popular indices in the world.

Writing editorials in The Wall Street Journal, which he founded, Dow talked about the movements of these indices and made forecasts about future market action based on what he saw. After his death, his successors at the paper assembled his thinking into a full forecasting model, which is now called Dow Theory.

Dow Theory consists of six principles:

1. The market has three movements
2. Market trends have three phases
3. Markets discount the news
4. The averages must confirm each other
5. Trends are confirmed by volume
6. Trends exist until definitive signals confirm the trend has reversed

The major movements of the market can be seen in the chart below. Dow understood markets never move straight up or down. There are always short moves against the trend. However, he believed the movements generally followed a specific pattern.

Dow called the long-term trend the primary tide. Secondary reactions are the intermediate-term corrections that interrupt the primary trend and move in the opposite direction. Minor day-to-day moves in the market are called ripples, which Dow said should be ignored. He believed it was best to follow the primary trend.

I believe the most important principle of Dow Theory is that the two averages must confirm each other. It takes new highs in both averages to deliver a buy signal and new lows in both averages to confirm a sell signal. 

This idea is reinforced by the sixth principle, which is that trends exist until definitive signals confirm the trend has reversed. In other words, the direction of the trend only changes when both averages confirm each other.

The DJTA broke above its late-2014 high on Dec. 8, confirming the highs in the DJIA and giving us a Dow Theory buy signal.

This is good news for the market overall, as stocks are likely to rise in the next few months. But it also means "discounts" on quality companies will become even harder to find.

Rather, they will be unless you use one of my favorite strategies, which pays you to buy stocks at a discount.

Here's how it works…

Let's say you really want to buy Apple (NASDAQ: AAPL). But at a recent price of about $117, the stock is trading just 1.4% off its 52-week high. 

You'd feel a lot more comfortable about buying AAPL if shares were trading for, say, $110, which is 6% below the recent price. It's a hugely profitable company, and analysts believe it could run to about $132 next year. So, if you bought at $110, you could potentially book a 20% gain over the next 12 months.

Now, you could place a limit order to buy AAPL at $110 a share. After all, it's not unthinkable to see a pullback in the market or some other event that causes shares to drop to your preferred buy price within the next month or so.

Then again, maybe it won't.

Perhaps you'll find some place to park your cash in the meantime and earn a little bit of interest while you wait. Then again, in today's low-interest rate environment, that's unlikely.

But there is a third option: selling puts.

For those who are unfamiliar with this conservative income strategy, you can, in effect, get paid for the chance to buy stocks at a discount by selling put options on them.

Put options give the owner the right -- but not the obligation -- to sell a stock at a specified price before a specified date. When you sell a put, you are obligated to purchase that stock from the put buyer if shares fall to the specified price (the option's "strike price"). 

Using the example above, you could sell a put option on Apple with a strike price of $110 that expires on Jan. 20 for a "premium" of around $0.35 per share.

The premium, or what I call "instant income," is what you receive from selling the option -- in this case, about $35 per contract. (An option contract controls 100 shares, so $0.35 x 100 = $35 per contract.) And it's yours to keep no matter what.

If AAPL is below $110 per share at expiration, you will be required to buy shares for that price. But remember, that's the discounted price you wanted to pay for AAPL in the first place. And because you already pocketed a premium for selling the put, your cost basis is actually $109.65 ($110 strike price - $0.35 premium).

That means if AAPL is below $110 or Jan. 20, you'll scoop up shares at a 6.3% discount to the current price.

And if AAPL doesn't fall to the strike price by Jan. 20, you are no longer obligated to purchase the stock, but you keep the $35 premium. (Keep in mind that premium is scalable. You would earn $70 if you sold two contracts, $175 if you sold five, $350 if you sold 10, and so on.)

What's great about this strategy is that you get paid to set the terms. You decide what you'd be comfortable paying for a stock should it fall to the specified price. And you set the time frame that you're willing to wait. It lowers your cost basis if the stock falls to your strike price, and if it doesn't, then you simply keep the premium as pure profit.

You can repeat this process again and again until you get to purchase shares at a price you like. And you can use it with almost any stock out there.

I recommend a put selling trade like this every week. If you're interested in getting my next recommendation or learning more about how I pick the right put options, follow this link.

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