1 September 2010, Financial Advisor

At the end of August 2009, the S&P 500 was trading around 1,030. A year later, it was virtually unchanged, trading at 1,050. Despite significant volatility that at one point had sent the market up nearly 20 percent to 1,217, stocks have spent the past year going nowhere. And prospects for the next year don’t look particularly sanguine as the economy seems to be sagging.

It is not easy to profit in this market. “Buy-and-hold” is far from a compelling strategy. But there is one approach that may lock in gains from this sideways-moving market, and it could very well involve stocks you already own.

Systemic economic problems will likely keep stocks from rallying over the next several quarters. Nonetheless, they will continue to move actively within certain price ranges, says Mark Scheffler, senior portfolio manager at Appleton Group Wealth Management with $135 million of assets under management. And trading within that range is how investors can make money.

When stocks are range bound for several months, Scheffler has observed a whipsaw effect as they reach their short-term peaks or troughs. “At these inflection points,” says Scheffler, “stocks tend to be more reactive to fundamental company or broad economic news. And this sensitivity tends to be noticeable when the market is broadly in a flat, trendless way.” This makes capturing a 10 or 12 percent gain over the short term a reasonable possibility. So investors may do well if they adjust both how they invest and their price targets to match current reality.

To help ensure this approach works, advisors need to first identify solid, profitable companies whose stocks have demonstrated clear trading patterns over the past several months. As they break lower, consider buying and then selling into a modest rebound. A stock trading at $20 only needs to inch up to $22 for a 10 percent gain.

Seasoned technical analyst at Miller Tabak, Phil Roth, sees merit in trading within a range. He agrees that having modest, disciplined price targets can help ensure investors sell out of a position before a stock’s pattern breaks. But he cautions “the longer a stock demonstrates a cyclical pattern, the sooner it may break out of that pattern—up or down.”
Roth prefers a different trading approach. He targets 20+ percent returns by recommending a stock when it breaks out of the top of its range–a standard technical trading strategy. He focuses on stocks that are demonstrating widening daily trading ranges as prices are trending higher on increasing volume.

To limit downside risk, he applies stop losses around 8 percent below his purchase price. So if he’s right half the time [which he is], these basic rules help achieve attractive total returns in virtually any market.

Look at What you Know

It’s not hard to find stocks suitable for this trade. If you’ve followed a stock for years, you may have a pretty good sense of its pulse—how it moves and how it responds to the broad market. So check your existing portfolio, even losing positions. You may find a potential winner.

One compelling example involves a preferred stock. Preferreds are interest rate- and credit-sensitive securities, and they have been as volatile as common stock during the financial crisis, creating unique opportunity.

The London-based global bank, HSBC, has a $50 preferred share,series Z that trades on the New York Stock Exchange. At par, it yielded 5.72 percent. The stock tumbled to $29 in spring 2009 because of fear surrounding payment of all bank dividends. This produced a current yield of 9.86 percent. But the stock has steadily rallied, and over the past year it has been trading between $38 and $46. Between May and July of this year, the range narrowed even further, trading between $39 and $44.

At the beginning of July, it broke below $40, dragged down by increasing doubts of economic recovery. But HSBC survived the banking crisis in good shape, emerging as one of the strongest global banks. Its capital and liquidity are solid. And current yield on this preferred was paying more than 7 percent, with a dividend that’s taxed at the 15 percent rate.

But what made this particular preferred even more enticing is its “cumulative” status. This makes the security almost as safe as a bond. Say the bank gets into so much trouble that it had to suspend its common stock dividend and all of its other preferred dividends–something that didn’t even happen to the Royal Bank of Scotland, the poster child of the banking crisis. When it eventually gets back on its feet, HSBC would have to pay back all missed dividends on the Z shares before it could pay one pence on the common. And for a bank stock not pay a dividend on its common shares is anathema.

When the HSBC preferred descended past $40, it was yielding six times more than the top money markets, and all of the above-mentioned characteristics provide a remarkable safety net.

The stock quickly bounced off its near-term low on announcement of healthy second quarter results and favorable review from European Commission’s bank stress test, climbing 15 percent in just six weeks, several points past its range-bound high.

Not Cherry Picking

Skeptics may think proof of range-bound trading is cherry picking performance after the fact. But patterns provide information: rings in a tree trunk, cirrus clouds, an electrocardiogram. Stock charts are evidence of current market sentiment.

Reading trading patterns is not an exact science. But when dealing with solid, profitable companies in a free market, certain price movements can suggest near-term moves. But investors must move decisively.

Ron Sloan, fund manager of the Invesco Charter Fund with $4.9 billion, says range-bound trading requires significant discipline in tracking, buying, and selling stocks. While a buy-and-hold investor, he’s starting to use this shorter-term strategy in trading around existing positions as a means of locking in modest profits when core holdings are not moving.

A key reason he has modified his thinking: market cynicism is undermining performance despite attractive fundamentals. Take Intel, for example, over the past four quarters. It has consistently topped consensus earnings estimates, rising sequentially from $0.33 in 3Q09 to $0.51 in 2Q10. June’s figures blew past the previous quarter by $0.09 or by more than 20 percent. But since mid-April when shares peaked at $24.37, they’ve been falling.

Blowout second quarter figures were unable to staunch the descent. The news initially sent shares from $19 to above $22. But over the past month through the last week in August, the stock broke below $18.50. “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.” And 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.

Many managers think selling out-of-the-money calls—where they collect a premium to provide another investor the right to buy a stock the manager presumably owns at a higher price–is another way to prop up returns in a range-bound market. Setting the strike price above the trading range and limiting duration of the option to a short time frame can enable owners of shares to collect several additional percent of yield without risking the sale of such shares at an inexpensive price. Managers also sell puts below a stock’s price range for the same purpose.

Broader Approach

While there is typically less upside in trading indices because they tend to be less volatile than individual securities, foreign country funds can provide some added pop because they also include foreign exchange volatility.

This was evident this past spring when the Australian dollar rallied above $0.93 in mid April. But the sudden global selloff in all risk assets sent the Aussie currency plummeting by 12 percent in less than two months as investors rushed into US dollar securities. By early June, the Aussie dollar fell to nearly $0.81.

Before the currency sold off, the Australian iShares, which tracks the country’s MSCI index in US dollars, peaked for the year above $25 in mid April. One month later, the index lost nearly 25 percent as it hit a 2010 low of $18.47. The index was hit by both the selloff 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 recent August issue, “Up Down Under”]. It suggested potential value in both the currency and stocks.

Then over the following weeks as panic 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. Index yield of more than 4 percent added to attractiveness of the trade.

If the Index was purchase at $19, more than10 percent would’ve been earned 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, purchase of additional shares at a lower cost increases 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.

Use of stop losses to limit risk is also useful. But set too narrowly, such as 8 percent below cost, can get you sold out of a trade very quickly. Set too far away, like 20 percent, can reduce its effectiveness. A simple rule: stop-losses must reflect an investor’s tolerance for risk.

Long term, a stock does reflect the fortunes of its company. But over a period of several months, when the broad market is indecisive, there can be disconnects due to investor confusion and a lack of conviction. Range-bound trading looks to exploit the volatility that comes from this lack of clarity, a state that seems likely to be with us for some time to come.