A couple of weeks ago, in "Nervous about the Index", the potential for a significant pull back in the Australia 200 index was highlighted. Now that the market has broken the support levels and a down trend is in place, there is a new challenge. Where and how can traders and investors join the unfolding sell off, to make trading profits and/or protect portfolios?
The fundamental picture remains largely unchanged. Even 150 points lower, in my view valuations are still stretched. Many leading stocks have just paid or are about to pay their dividend, reducing their immediate appeal. And three weeks of falls in the US S&P 500 is weighing on local prices.
Luckily for both traders and investors, a 1,2,3 entry is unfolding on the charts. This is a time-tested trade entry method, and has many different names, including a "hook trade" and the "Ross hook", named after legendary trader Joe Ross.
Points 1 and 2 are illustrated on the chart. Point 3 is formed if the index drops through the level of point 1 - in this case, at 5746.2. This is the sell entry signal. The wider MACD is suggesting further negative momentum, and the chance of a drop through 3 should not be discounted.
Traders find advantages in this method because of the clearly defined entry and stop loss levels. Selling just below 3, at a point say between 5740 and 5744, the classic method is to place a stop above 2, at 5867. However, many traders are willing to say the signal has failed if the index trades back above 3, and will place a tight stop just above 5750.
For investors it can be a matter of "locking down" current exposures. A portfolio that is composed of stocks broadly in line with the 200 index may be hedged using CFDs. It's a matter of determining the value of the portfolio, and dividing by the index level.
Example: hedging a $100,000 portfolio on a fall through 5740
Divide $100,000 by 5740 = 17.42
Selling 18 Australia 200 CFDs will offer an offset to portfolio losses should the market continue to fall.
It's important to note that this hedge will exactly match the portfolio only if all 200 of the index stocks are in the portfolio, in their index proportions. Nonetheless, where a portfolio is broadly in line with the index, this hedge will gain in value as the value of the index, and the shares, fall. The difference in the change in values between the CFD hedge and the stocks is known as tracking error - but this may be positive or negative.