How To Think Like A Trader

As many of you will be aware, there are two basic approaches to stock selection, commonly known as top-down and bottom-up. The former involves looking at big picture economic factors, arriving at a base scenario and then finding trades that will profit when that scenario plays out. The latter is about starting with a company’s fundamental position and assessing whether that individual stock will outperform or underperform the general market. My background in currency and commodity markets makes the top-down approach a more natural one for me to use, but as I have transitioned to more stock plays I have tended to use both, albeit for different purposes.

Over an extended period of time stock markets trend upwards, so investing in solid companies that have growth potential is the obvious long term strategy. Short term considerations specific to the industry involved or the broader economy play a part in the timing of such trades, but the ultimate goal is long term appreciation. That makes a bottom-up approach best suited to investments whose time horizon is to be measured in years rather than weeks or months. Top-down, however, plays more on the cyclical nature of markets and economies, so is better suited to trades designed to be closed out in a relatively short time.

It should be noted that in both cases I am still talking about trades with time horizons measured in weeks and months at a minimum. Intra-day trades where the holding period is even shorter, minutes or maybe a couple of days at most, have a completely different set of criteria for selection. In those cases technical considerations matter more than anything. A stock may bounce off of a support or resistance level initially and good profit can be made on those moves, but big picture, fundamental factors will decide the direction and magnitude of any long term move.

Sometimes, a top-down analysis will suggest a short term trade that is in direct contradiction to that suggested by a bottom-up approach. It would be logical to assume that that is a time to back off and leave well alone, but, because of the time span difference, it can sometimes be an opportunity in itself. That is the case right now in the realm of E&P MLPs.

First, the big picture suggests that things for most of those companies could be tough over the coming couple of months. The biggest factor in oil and gas E&P MLPs’ profitability and their ability to make distributions, and therefore improve their stock price, is the price of oil. A bounce back in the oversold condition of oil along with the Dollar retreating from its highs has caused a rally in oil, and therefore a rally, or at least an arrested decline, in companies such as Viper Energy (VNOM) and EV Energy Partners (EVEP).

The problem is that both of those positive influences look like reversing course temporarily over the next few weeks.

The Dollar had come a long way in a short time so some correction was almost inevitable, but the fundamental factors that drove its strength are still in place. QE has finished in the U.S. and, if anything, some degree of tightening looks to be on the horizon. Meanwhile the Japanese and now the Europeans too, are still following inflationary policies. In that situation, simple supply and demand suggests that the Dollar’s rise isn’t over yet.

As the Dollar backed off of the highs, so oil continued to bounce off of its lows, as one would expect. There are, however, reasons to believe that WTI will turn back downwards again before resuming its recovery. If the Dollar does turn back up then that alone will put pressure on oil, but it should also be considered that many of the worries that contributed to the initial collapse are still present. The ECB is trying, for sure, but Europe’s problems haven’t gone away, oil is still flowing from the shale and sand wells in North America, and alternatives are still gaining traction. Little wonder then, that WTI has twice failed to hold above $60, something that in itself suggests a run back down.

These factors are joined by a couple of others to create a kind of “perfect storm” for E&P MLPs. That tightening that I mentioned by the Fed will take the form of a rate hike, which will naturally put downward pressure on MLPs who derive much of their value from their role as an income producer. In addition, according to the latest short interest report, the shorts in these stocks have now been well and truly squeezed out. That removes a significant source of support.

There would, therefore, look to be significant downside risk for these companies in the immediate future. Extend out a while, though, and a simple reversion to the mean would suggest that most of them will trade higher at some point. The obvious strategy then is to short a couple of select companies that will come under pressure but are fundamentally sound, always with a view to buying twice as much once a target is reached, leaving you with a viable long term, long position. My choices would be the two mentioned above, with a target of $14 for VNOM and $12.50 for EVEP. Stops should be set reasonably tightly as, if the big picture scenario doesn’t play out, you wouldn’t want to stay short for long.

Traders are trained to see opportunity everywhere, and when you think like one even contradictory messages can give a clear signal. Selling now to buy later gives the possibility of profit both ways with tight stops limiting potential losses, and as such constitutes the ideal trade.