"Because this market doesn't seem able to sustain positive news," observes Sloan, "selling immediately into such announcements may be the best way to preserve wealth."
He says he wouldn't be surprised if this kind of behavior continues into next year, suggesting a need to consider the merits of short-term trades with modest targets. Another way to prop up returns in a range-bound market, say many money managers, is to sell "out-of-the-money" calls. This allows a manager to collect a premium by allowing other investors the right to buy a stock he owns at a price above current market levels. By setting the strike price also above the trading range and limiting the duration of the option to a short time frame, the share owners can collect extra percentage points of yield without having to sell shares at an unattractive price. Managers can sell puts below a stock's price range for the same purpose.
Broader Approach
There is typically less advantage in trading indices because they tend to be less volatile than individual securities. But foreign country funds offer some added pop with the foreign exchange volatility.
This past spring, the Australian dollar rallied above $0.93 in mid-April. But the sudden global sell-off in all risk assets sent the Aussie currency plummeting by 12% in less than two months as investors rushed into U.S. dollar securities. By early June, the Aussie dollar had fallen to nearly $0.81.
Before the currency sold off, the Australian iShares, which tracks the country's MSCI index in U.S. dollars, peaked for the year above $25 in mid-April. One month later, the index had lost nearly 25%, hitting a 2010 low of $18.47. The index was hit by both the sell-off in the local currency and a comparable loss in local shares. This collapse was driven largely by fear, not the country's fundamentals, which are among the strongest of any developed market. (See our article in the August 2010 issue of Financial Advisor, "Up Down Under.")
The panic suggested there was likely potential value in both the currency and stocks. Over the following weeks, as the fear subsided, both the Australian dollar and stock market rebounded. In early June, they both retested their recent lows but did not break through them-a good technical sign, suggesting a bottom is forming.
The Australian dollar and stocks then rallied higher with the MSCI index hitting nearly $21 before retreating back toward $19. This produced another positive pattern: higher highs and higher lows. The index yield of more than 4% made the trade even more attractive.
If an investor had purchased the index at $19, he would have earned more than 10% by the first of August as the fund broke above $22. One can't overemphasize the need to sell once a target is hit. The strategy is frequently compromised when investors hold out for additional gains that don't materialize in a range-bound market.
Another way to manage risk is to split an investment into two tranches. If the stock breaks down below the initial purchase, an investor can buy additional shares at a lower cost to increase the odds of a winning trade. This strategy could limit total gains if the stock immediately rallies and the second tranche can't get placed at a lower price. But it protects against unpredictable downward spikes that the market is prone to during bouts of range-bound trading.
It's also helpful to use stop-losses to limit risk. But if you set them too narrowly, at 8% below cost for instance, you can get sold out of a trade very quickly. If you set them too far away on the other hand, say at 20%, the strategy won't be as effective. A simple rule: Stop-losses must reflect an investor's tolerance for risk.