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The fresh wind at the back of homebuilders…assessing the strength of the trade today…what if our timing is wrong? … a powerful risk mitigation tool

Today, let’s look at a trade I suggested two years ago that was very profitable.

But more importantly for you, if you’re not in this business, we’re going to discuss how to make it more profitable starting today. We will also incorporate a strong hedge to protect our profits if the market starts to head south.

Let’s jump in.

The bull market in homebuilding stocks continues to climb

On April 20, 2022, Digestwe suggested that aggressive investors could initiate a trade on the iShares Home Construction ETF, ITB. Owns homebuilding heavyweights including DR Horton, Lennar, NVR, Pulte and Toll Brothers.

If you had acted on it Digestyou’d be up 115% right now, roughly 4X beating the S&P’s 29% return over the same period.

Source: StockCharts.com

Despite this triple-digit pop, ITB looks poised for more gains today for one main reason…

The new rate cut cycle.

As you know, the Fed cut its target rate by 50 basis points a week ago. It also indicated it expects two more cuts of a quarter point by the end of the year, followed by four more cuts of a quarter point next year.

These lower rates will affect a handful of sectors, with housing/housing among the biggest beneficiaries. There are two major reasons why:

• Lower mortgage rates will lower the total cost of home ownership, leading to more demand for homes
• Lower interest rates reduce borrowing costs for homebuilders, which increases margins and improves profitability

It’s a double win.

It gets better…

From a valuation perspective, ITB has plenty of runway in front of it to support the continuation of its run. While the total S&P 500 is trading at an expensive price-to-earnings (PE) ratio today of 29.9, ITB is trading at a PE of less than half that – just 13.9.

While this could mean ITB has bullish headwinds on a macro basis, is now – right now – a good time to enter this trade?

To help with our analysis, we’ll borrow from our hypergrowth expert Luke Lango and his trading service Breakout Trader.

Specifically, we’ll look at two of Luke’s favorite indicators: the relative strength index (RSI) and the moving average convergence/divergence (MACD) indicator.

RSI is a momentum indicator that measures the extent to which an asset is overbought or oversold. A reading above 70 suggests an asset is “overbought” (and likely ready to retreat as traders take profits), while a reading below 30 means it is “oversold” (and poised for gains as bargain hunters bargains step in and buy).

Meanwhile, the MACD indicator reflects changes in the strength, direction, momentum and duration of a price trend. Traders use this tool by analyzing the location of the MACD line relative to the signal line.

In its most basic interpretation, if the MACD crosses above the signal line, it is considered a bullish crossover and potentially a buy signal. The opposite is also true.

Below, let’s look at ITB along with RSI and MACD.

For the RSI, note that it comes in at 61. This suggests healthy, bullish price momentum in a move that is not yet overbought. However, notice that the RSI line is trending lower after being above 70 last week. This reflects recent weakness.

For the MACD (black line), it has risen above the signal line (red line) to a relatively high level, although it is not at a nosebleed reading. Again, this suggests a broader, optimistic movement, but not one that feels overextended.

However, note that the MACD has started to move sideways to a slight downside since the middle of the month. This suggests that the latest price movement is on the downside.

Source: StockCharts.com

So what is takeaway?

Well overall there is a lot of strength here, however the latest price action suggests that the bullish move is getting tired. That means we could find ourselves underwater for the next few days/weeks if we start a trade today.

Clearly, that doesn’t sound great at all. So we wait?

We could. Of course, there’s always the chance that the bulls come roaring out tomorrow and ITB hits 3%+ and goes to the races, making our caution look like a bad move.

How do we solve this?

Which brings us back to last night…

Last night our macro expert Eric Fry sat down with Keith Kaplan, CEO of our corporate partner, TradeSmith.

Part of their discussion highlighted a number of quant-based trading tools from TradeSmith that are designed to help investors optimize their trade management.

One of the tools I find invaluable is TradeSmith’s trailing stop tool. This is because it takes into account the specific volatility of any stock/ETF to help investors answer a crucial question…

When you’re in a pullback, how do you know if it’s just normal volatility versus a “this time is different” drawdown to avoid immediately?

If you don’t know this answer, you may be prematurely shaken out of a great trade and watch your earnings snowball, watching you from the sidelines…

On the other hand, without knowing this answer, you may be stuck in a bad trade expecting it to bounce back, only to watch your losses accelerate until it’s a portfolio-destroying loser.

At the heart of this are two important truths about trading…

Volatility is not the same as risk, and volatility is not uniform for all stocks

Luke made this point in a past issue of Breakout Trader.

Big picture, risk management is the name of the game when it comes to safe long-term trading. To this end, stop-losses and wise position sizing are extremely important.

But many newer traders don’t put enough thought into their stop-loss amounts. Instead, they apply the same stop-loss percentage to all their trades.

That doesn’t make sense.

Below, we compare two stocks: perennial blue-chip Coca cola (KO) and Matador Resources (MTDR), an oil and gas exploration company.

From October 2021 to mid-May 2022, both stocks are up exactly 27%. But the paths they took to get there were wildly different.

See for yourself. The matador is in green. Coke is in black.

Source: StockCharts.com

Coca Cola’s path is much smoother than Matador’s relatively “violent” series of ups and downs.

With this in mind, would it have been appropriate to use the same stop-loss percentage for both stocks?

Of course not. That would be ignoring the reality that Matador’s normal volatility is much higher than Coca-Cola’s.

But that doesn’t mean Matador is a “riskier” stock. It just means that traders need to account for this higher volatility in their position size, trade expectations and stop-loss levels.

TradeSmith’s trailing stop tool takes these unique volatility fingerprints into account, generating a proprietary “Volatility Quotient” (VQ) reading that helps investors know how much volatility is normal and to be expected.

Here is the official description:

The Volatility Ratio (VQ/Risk) indicates how volatile an investment is based on the historical price action of at least one year. This ensures that the user assumes the appropriate risk in any trade based on TradeSmith algorithms.

We use VQ to determine the trailing stop for our health indicator and the VQ trailing stop for positions tracked in TradeSmith. The lower the number, the more stable the movement of that stock. Higher percentages indicate that the stock is more volatile in its market movements over time.

This allows investors to identify custom stop-losses for each specific stock they own based on their unique entry point.

So how much should an ITB investor give if they enter a trade today?

As I write, TradeSmith’s VQ algorithm suggests that normal volatility for ITB could lead to a 23.47% rally. So, we could set our trailing stop loss percentage at 23.47%, as a drop higher than this would suggest a move beyond normal volatility.

Now let’s take this a step further. Let’s use this VQ reading to help us define our risk and set an appropriate position size.

For example, let’s say we want to limit our potential downside to $1,000 if things don’t go as expected. In other words, this is the maximum we want to risk losing. Well, based on our VQ reading (and chosen stop loss percentage) of 23.47%, that means we can invest a total of $4,261.

Mathematically, here’s how it works…

If $4,261 is our initial investment and ITB drops to the 23.47% stop loss, that leaves us with $3,261, which is our “max loss” of $1,000.

So with this tool, we can calculate how much to put into our ITB trade, identifying exactly where we will get if it turns against us and what that would mean for our portfolio value.

I will add that TradeSmith also has an entry timing tool that provides guidance as to when bearish momentum has changed and investors are likely at the start of a new run.

If you want to learn more about TradeSmith and these tools, click here to watch a replay of last night’s event with Eric and Keith.

Regarding ITB, we remain bullish and believe the next six to 12 months will reward investors who initiate a trade today

That doesn’t mean it won’t be volatile, and based on the technical charts, it doesn’t mean we won’t have some temporary losses if we buy today.

Despite this short-term uncertainty, all the signs we see point to much higher long-term gains.

And if we are wrong? Well, by using an advanced stop-loss tool that reflects the specific historical volatility of ITB, we’ll know when to call it a day.

Fortunately, we don’t see that happening anytime soon.

We will keep you updated.

good evening

Jeff Remsburg