Traders Could Make a Quick 100% When This Bubble Bursts

Academics generally view the market as a random walk. The next price move is just as likely to be up or down under this view because no one can tell what the markets will do in the future. On a second-to-second level, they are almost certainly correct. Successful traders recognize this and don't usually try to trade thousands of times a day from home. High frequency trading firms dominate that time frame and the individual trader will probably face rapid losses trying to compete with those firms.

While the very short term might be impossible to trade, in the longer term, stocks show a strong tendency to go up and that is why a number of studies show that stocks go up 7%-10% a year, on average, in the long run. Stocks don't move straight up but there are more up years than down years in the long run, just as there are more up months, weeks and days over long periods of time.

Although there will always be a group that believes markets are random, they almost all agree there are some exceptions to that rule. One of the most widely studied exceptions is relative strength (RS), which is probably the only trading tool that has survived academic scrutiny.

RS can be measured in many ways but my favored practical approach is the one I used to build my 26-week rate of change (ROC) system. This system finds the strongest ETFs in several asset classes, adds some risk management rules, and then delivers market-beating gains over the years.

RS, and the 26-week ROC indicator, can also be used to find market excesses. Studies and trading experience confirm that rapid market moves are often quickly reversed –- in other words, when prices move up too fast they usually suffer a short-term decline.

An example of this is shown below with a chart of PowerShares QQQ (NASDAQ: QQQ), an ETF that tracks the tech stocks in the Nasdaq 100 index. This index doubled in six months before peaking in March 2000. It then fell 90% as the Internet bubble imploded.

Traditional indicators like the stochastics shown in the center of the chart became overbought and stayed overbought. The 26-week ROC, however, gave a sell signal only two weeks after the top.

Bollinger Bands have been added to the ROC at the bottom of the chart. The Bands are set 2.1 standard deviations apart and use a 50-day look-back period, which are the parameters recommended by John Bollinger in Bollinger on Bollinger Bands. He noted these parameters work better with indicators than the traditional 2 standard deviations on 20 days used with prices.

In testing with the stocks that make up the Dow Jones Industrial Average, this simple trading system is profitable. Sell signals are generated when the ROC falls below the upper Band after crossing above it. Finding simple strategies to short stocks is a difficult task given the upward bias in prices over time.

In the current market, master-limited partnerships (MLPs) have taken the place of Internet stocks as a guaranteed source of wealth in the minds of many investors. An ETN that tracks this sector, JPMorgan Alerian MLP Index ETN (NYSE: AMJ), is at news highs, but ROC shows that the price rise is probably near an end.

AMJ seems to have moved too far, too fast and is a short trade opportunity. Alternatively, put options can be used to profit from the expected decline. The initial price target is the support level at $39. March $41 put options are trading at about $0.80 and would be worth at least $2 if AMJ falls to $39.

Recommended Trade Setup:
-- Buy AMJ March 41 Puts for $1 or less
-- Set stop-loss at $0.50
-- Set initial price target at $2 for a potential 100% gain in two months

This trade shows how the ROC indicator can be used to find short trades. In my system, I focus on long trades, but for aggressive traders, AMJ is the best trade I see while we wait for the next signal from the 26-week ROC system.

There are no changes in the portfolio I follow here each week:

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