Option Investor
Trader's Corner

If It's Too Good to Be True

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Last week, I discussed the way I might go about studying charts when deciding what might happen to prices. How would I put that into practice when making decisions about investments? I can show you with a real-life example of when I decided against an investment, at least.

Here's the setup. From November through early January, several experienced fellow traders talked to me about their high-yield investments. These weren't neophytes in the trading world and the money they were making wasn't chump change. They had done their due diligence, studying charts, newsletters, books and fund ratings. I should try this category of investments, several urged. I could make dividends of 10-15 percent and participate in gains in the underlying, too.

I bought a book. Wincing at the title and the hyped-up if easy-to-read prose style, I made my way through the evangelizing first chapters into the meat of the book. These investments weren't fly-by-night bulletin-board type stocks, the book assured me, but "bond equivalents" that were "too good to pass up." They were "backed by strong underlying businesses." They would "really shine in tough times." These were investment grade entities, a former trading mentor told me, rated investment grade by Moody's and S&P.

You know where I'm going with this, don't you? Lately, we've been hearing a lot about securities rated investment grade by Moody's and S&P being subsequently downgraded. These high-yield investments included some terms and names we've heard mentioned on television this last year, not always in positive terms. For example, does New Century Financial ring a bell?

Annotated Daily Chart of New Century Financial

REITS weren't the only recommended high-yield investments to suffer. New taxes on Canadian income trusts late in 2006 adversely affected Canadian Business Trusts, a category of high-yield investments that were suggested as potential investments to be investigated in the book.

Annotated Chart of Precision Drilling Trust

So what saved me from jumping into one of these investments?

Most importantly, I didn't always understand them. They were packaged-up things. Like Warren Buffet, I want to understand a company or security, particularly if it's a long-term investment, and the book proposed these as long-term investments so that one could continue collecting those high yields. I knew what a convertible security or closed-end fund was, but I didn't know what an IDS (Income Deposit Security) was, and I didn't understand what could go wrong with a MLP, a Master Limited Partnership. I needed more time to investigate. By the time I investigated, some of the Canadian Business Trusts were already rolling over, and I was alerted that I would need in-depth research before putting my money at risk.

Another reason I hesitated? Volume wasn't large enough in some of these securities. Years ago, I had often traded the XAU's options but had given up trading them after I'd once been unable to exit in a fast-moving market. The volume was so low in these options that I was at the mercy of the market maker, and I think someone had to go hunt up that market maker from wherever he was having his lunch before a decision could be made. I didn't like trading low-volume stocks or options, and I didn't think I wanted to trade low-volume high-yield securities, either.

Annotated Daily Chart of Gabelli Utility Trust (GUT)

In addition, I saw some chart characteristics that worried me. Last week, my Trader's Corner article covered some of the processes I go through when considering a play, either an investment in a security or its options or some other tactic. Those were the same processes I employed when studying these investments.

Since New Century Financial (NEW) was one of the securities I had studied, let's look at what might have been visible on that chart back in late 2006 and early 2007, before NEW imploded.

Annotated Daily Chart of NEW:

I never saw that low-volume test of the mid-channel support that I had wanted to see. Such a test and volume pattern would have indicated that there was no more supply to be absorbed, and I would have then expected a subsequent bounce up through the channel. Instead, by the right-hand side of the chart, I had seen an instance when NEW attempted to bounce back above $32.00 on a strong-volume day, only to be knocked back by the end of the day and to close lower the next day. NEW was still being sold on bounces and sold more heavily than it had been in a while at resistance tests.

Meanwhile, the Keltner charts that I prefer and discussed last week were revealing even more troubling information.

Annotated Weekly Chart of NEW:

To sum up, my unfamiliarity with the securities and how investments in them might go wrong, my dislike of involvement in low-volume securities and some chart characteristics saved me from jumping into investments that wouldn't have worked well.

Does that mean that these high-yield investments are all bad and that the book's author and my trading friends were all wrong? No way.

Some of the potential investments detailed in that book and chosen by my trading friends have weathered the current market volatility quite well. One tanker stock I checked is now almost double its 2006 closing price, and both the book and one of my trading friends specifically suggested this tanker's stock. In addition, the book's author advises all the appropriate measures before investing in these high-yield securities: research, starting small, diversifying, limiting exposure to a particular security to five percent of the portfolio, and evaluating securities periodically with a goal of weeding out poor performers.

The author also warned that investments were chosen for their yields as well as their possible price appreciations and that some volatility should be anticipated. Although appropriate stops should be set, these weren't investments that would be actively traded.

Although deciding against NEW late last year and early last year didn't require an extensive knowledge of technical analysis, the process discussed in last week's Trader's Corner article did help me avoid a few investments I'm glad I didn't take.

Now I'm going to go back and study the rest of those suggested types of securities to see how they weathered the credit crunch, looking at their charts, learning what I can, seeing if they still look too good to be true.

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