Thursday, December 26, 2013

Industry Risk Cycle

The rotation of stocks within an industry is as follows as taught by "option addict" found at ibankcoin and trading addicts.
My view is only a little bit different, but it is more complex and thus this method above is probably more practical. The most simple explanation is that sentiment moves from an extreme low to an extreme high and back and it manifest itself in various layers, but the layers get complicated due to different goals and size of capital needed to be moved. Rather than get into the complications right now I better explain this cycle first.
When you expect a rotation into an industry, you should understand there is a bit of an order that TENDS to occur as a result of the perception of risk and other factors. By knowing this tendency you can use it to anticipate movement and provide a bit more focus into a particular name and boost your results.

The market will usually be driven by a leader outperforming and then the trending momentum names will continue their charge strong. The rotation into momentum has a lot to do with liquidity and the largest players providing the positive equity and signalling a more long term sustainable rotation into the industry. This way the smart money can get ahead of the rotation that will take these mega institutions a lot longer to accumulate. The laggards are again an instance of the recognition that the industry will continue its rotation, and that those that lagged the move are relatively undervalued compared to how they were relatively valued before the rotation began. Also, there is a perception that laggards are riskier as those who buy it are more than likely going to have to wait on a loss before the return goes positive. Finally once you have the liquid laggards there is nothing left that hasn't really moved besides the companies that are perceived to be the kind you don't touch with a ten foot pole. Rather than chase these, the peddle goes to the floor as the buyers simply target the high short interest stocks. These are companies that people have been betting against but now as the tide has turned, the shorts will eventually have to cover in and if they get enough capital in there and trigger a short squeeze, they can simply CREATE liquidity through the short sellers margin calls and go for the big short squeezes. Finally, once everyone is starting to become convinced of the move, the short sellers will cover the names they have a profit in that they intended on shorting to zero (as a result of the margin call?) creating the bottom of the lowest quality names and also there will be some liquidity from the retail investor always predictably showing up late to the party chasing performance.

You'll notice that "liquidity" is a common theme I mentioned above. That is because my knowledge of WHY this occurs has a lot to do with my understanding of other principals that I use to infer an entirely new way to look at the cycle as a "liquidity cycle" within an industry and ultimately a more complicated look at the risk cycle. I will save this for another time.

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