The Time Magazine cover from July 13, 2005, the peak of the housing bubble, extolling the virtues of buying real estate.

There are many terms thrown around when folks talk about the financial crisis. Last year especially, the news was awash with terms like “Credit Crunch,” “Bailouts,” “Derivatives,” and you guessed it… “Housing Bubble.”

The financial crisis can seem complicated, but I view it as being very simple, and I will attempt to try and explain exactly what happened in this series of articles. I’m starting here because the crisis really started with the real estate market. If you can understand what the housing bubble was and what caused it, you can make sense of all the other events that went on among the mayhem.

Introduction to the Housing Bubble

First, some background. After the recession of 2001-2003, buying real estate was cool. As Tony Soprano would say, “Buy land, kid - they’re not making any more of it.” Whether it was due to the too-good-to-be true rates of adjustable rate mortgages, Federal regulatory policy that encouraged home ownership, and skyrocketing prices, everybody who was anybody was buying a house.

It wasn’t just wannabe homeowners either. In fact, the bubble was fueled by opportunistic institutional investors and speculators who identified value in real estate from early on. Banks, insurance, hedge funds, and loads of institutional money poured into real estate with reckless abandon, and many people made a ton of  money doing it.

As with any bubble, the housing market eventually peaked. In a twist of ironic fate, that peak likely occurred on the exact day that Time magazine published the cover shown above. If you look at a chart of Tol Brothers, TOL, one of the largest homebuilders, you will see that the stock price reached a maximum on that very day, June 13, 2005.

Toll brothers, one of the largest housing stocks, peaked on the exact day that Time published its house-loving cover.

Lending and Mortgage Speculation

Banks and other mortgage lenders, caught up in the housing frenzy, made it incredibly easy to obtain mortgages at low rates. But what exactly were these mortgages and why were they so popular?

Mortgages, like options, futures, and swaps, are derivatives that derive their value from an underlying asset. Mortgages derive their value from property. A mortgage essentially allows you to posses property at a fraction of the price, so they are a highly leveraged asset. The homeowner then becomes indebted to the bank.

Banks like to invest in mortgages because over time the homeowners will pay back the bank along with the interest accrued during the payback process. The bank then sets the rate of the mortgage using a complex risk model that theoretically takes into account all risk factors for the loan.

High risk borrowers are charged higher interest rates in order to compensate for the greater chance of default, or inability to pay back the loan. Low risk borrowers are charged lower rates, since they are less likely to default on their loans. Theoretically, the banks should make money no matter what.

Notice how I use the word, “theoretically,” when describing the risk models used by banks to determine the appropriate interest rate.

In engineering we learned that no model is perfect, and the banks’ risk models were no exception. Unexpected disturbances or variables that were not accounted for in the model may surface and cause instability. The now defunct Fannie Mae and Freddie Mac are perfect examples of mortgage lenders who developed some incredible risk models to allow them to price some very complicated adjustable rate mortgages. It turns out that they failed to account for macroeconomic factors that were beyond their control. More on that later.

It is important to keep in mind that many of the mortgages out there were not very simple. Terms abound for complicated mortgages, which were sold a dime a dozen to now homeowners. Most of these were adjustable rate mortages, or ARMs, which, unlike fixed rate contracts, were subject to changed interest rates. Many homeowners were taken by surprise when their mortgage rate increased to more than double than what they had expected to pay.

The end result of the mortgage frenzy is that hundreds of thousands, if not more, Americans were tied up in mortgages for homes they could not afford. Enticed by the sweet prospect of owning their own piece of the American dream, these men and women found themselves up to their eyeballs in debt.

The Rise of the Mortgage Backed Security

The housing bubble might not have been such an enormous problem were it not for mortgage backed securities. These securities allowed the risks assumed by various financial institutions to spread out through the entire financial sector, and may well have contributed to the violence we saw in the stock market in 2008 and 2009.

These arcane financial instruments are derivatives of derivatives, meaning that they derive value from a security that derives its value from an asset. As such, they are highly leveraged and a small move in property values can cause big value swings in the mortgage backed securities.

I am not an expert in exactly how these derivatives were constructed, but in the simplest sense, this is how I would describe them. Financial institutions took many different mortgages, sliced them up into multiple pieces, and categorized them by risk level. They then mixed pieces of equal risk level together and packaged them up into financial products and started trading them.

Picture a piece of music, written down on paper. Think of it as a derivative, in that it derives its value from a song. If there are a lot of eager musicians, lots of songs will be written, and lots of risk takers are willing to finance those musicians, in the hopes that the song will make it big like all songs seem to be doing at the moment.

Now, imagine taking that sheet music and cutting it up into sections: verses, choruses, movements, whatever. Then decide which sections are the best and which are the worst. If you own lots of different pieces of music, then you decide to compile all the good sections into one folder, the average sections into another folder, and the bad sections into another. Then you sell those folders, claiming that the buyer will have the rights to the portions of the songs included in the folder. Buyers who buy the high quality music have the best chance of making money off the folder, but they pay a high price. Buyers who purchase the bad music don’t have a very good chance of profiting, but they don’t have to spend that much.

A mortgage backed security is like a folder of good, bad, or medium music snippets, only you replace the music snippets with mortgage slices. If the value of the underlying asset, whether it be music or homes, decreases, then everyone who owns some of these securities is in big trouble.

Financial institutions took a big hit when housing prices started to fall, but the pain was exacerbated by the systematic nature of the risk and the leverage associated with these securities. The slicing and dicing of the mortgages made it very difficult to know which properties were involved with which securities, and caused risk to be spread out all over the globe. This is why the US government uses terms like systematic risk when describing the crisis. The risks taken by lenders went from being individual risks to being systematic risks. If property values tank, then the entire system fails. That is exactly what happened.

Then the Housing Bubble Burst

I don’t claim to know a whole lot about bubble economics, but what I do know is that they burst. I don’t know why they happen, but they do. As a trader I see bubbles come and go all the time. Stocks become overbought and oversold all the time. It’s a shortfall of our economic system.

When the housing bubble burst, here is what happened:

When housing prices started to fall, financial institutions that were long real estate (most of them) started to see huge losses. It was a systematic problem, due to the widespread nature of mortgage backed securities, and 30:1 leverage only added fuel to the fire.

In order to compensate, the lenders went back to their risk models, which spit out a new number. To combat the loss in value, the lenders increased rates on their borrowers. As rates went up, more homeowners defaulted on their loans.

If you bought a house thinking it was worth $1 million, putting $100,000 down, and saw its value drop to $500,000, it makes much more sense to walk away from the mortgage than it does to continue to pay out money to the bank for a house that is worth half of what you are paying for it.

Banks then raised rates more, which in turn caused more defaults, and so on, in a positive feedback cycle. The risk models used by mortgage lenders were unstable under these conditions.

All of the lenders were then left with billions of dollars in worthless homes on their balance sheets with no foreseeable prospects for making much of that money back. Trying to sell the homes at fire sale prices didn’t seem to make much sense either. Banks were facing huge losses, and it seemed that nothing they could do would fix it. Investors don’t like to see that, let me put it that way.

By early to mid 2007, most financial stocks reached a high. From there, financial stocks started to creep downhill. In order to cover all their debts, retail and institutional investors began to liquidate their assets, which, in many cases, meant selling stock. So not only did bank stock prices suffer, but the stock market as a whole started to go downhill.

Conclusion

Banks were in a tough spot. They were left with lots of bad assets and no way to get rid of them. Amidst these challenges, the banks were forced to curb their lending. Without lending, the credit markets quickly froze, and suddenly nobody could get any business done. That will be the subject of the next article in the series: The Credit Crunch.

What I can teach you are some of the tricks I’ve discovered on stockcharts.com that nobody knows about. If you use them wisely, you may find yourself a little bit richer. If you want to get access to all of the strategies I use, you should download my new eBook, which covers everything from market basics to winning strategies.

Track the Crack (spread)

I couldn’t resist the catchy headline, but in all seriousness, following the crack spread can help you to be profitable trading the refiners.

What is the crack spread? The crack spread is the difference between the price of gasoline and the price of crude oil. The process of converting crude to gasoline is what of oil refiners do, and is referred to as “cracking,” hence the name.

The crack spread has been very good for refiners lately.

When oil is cheap relative to gasoline, refiners like HES, VLO, and TSO are more profitable, since they can buy crude cheaply and sell gasoline at a higher price.

So how does stock charts fit in? They allow you to compare the price of oil and gas conveniently on a relative strength chart. The ticker symbol for crude is $wtic and the symbol for gasoline is $gaso. If you type $gaso:$wtic into the symbol field and plot a sharpchart, you will get a direct relative strength comparrison of the two commodities. View it as a line chart over a period of a year for the best results.

When this value gets to be high, the crack spread is favorable for the refiners, and you should look to buy into any weakness in the group. Likewise, when the crack spread is poor, you should look to be short the refiners, or at least avoid any longs.

Scan for Candlestick Patterns

If you like trading candlestick patterns, you can take the legwork out of it by using stockcharts’s automatic scanning engine.

The link above gives you access to a ton of different scan criteria. If you scroll down to the Candlestick Patterns heading, you will find a list of all the different patterns and how many stocks fit the criteria.

Most people don’t know this, but a paid membership will allow you to create your own custom scans with as many criteria as you want. Finviz will do this for free, but stockcharts has some cool features like point and figure patterns that Finviz doesn’t have.

Understand Market Posture with Bullish Percent

If you type $BP into the symbol box and hit go, it will give you a rundown of all the different bullish percent indexes.

Alternatively, you can use this link.

If you have never used bullish percent before, they are an excellent resource. I check each sector’s bullish percent value each morning before the market opens. The granddaddy of all bullish percent indicators is the $BPNYA, which tallies up the number of stocks on the entire New York Stock Exchange that are on buy signals. It is the most reliable indicator, in my mind, of market posture.

For more on bullish percent, read my book. I’ll remember to do a post on bullish percent at some point.

$NYA200R - How many stocks are above their 200 day moving average

This ticker symbol tells you just that, but it doesn’t just tell you, it gives it to you in visual form. This is a very reliable indicator of how bullish things are for the long term, similar to the $bpnya.

Much in the way $bpnya looks at how many stocks are on buy signals within the NYSE, the $NYA200R gives you a good idea of how many stocks are above their 200 day moving average, which is watched by almost all major market players.

You can also use $NYA50R for the 50-day moving average and $SPXA… and $NAA… for the S&P and Nasdaq, respectively.

View Volume by Price

This has to be one of my favorite hacks. I was amazed when I discovered it, because it’s been extremely helpful.

If you are familiar with trading market profile, it should be pretty clear how cool this is, but if you’ve never used market profile before, here’s why it’s awesome.

Prices tend to change quickly when they reach a price level where very little volume has been traded. They move slowly in price ranges of high volume. This means that when price breaches into low-volume territory, opportunities for profit arise. We’re familiar with this phenomenon in the form of breakouts.

Knowing where the low-volume “pockets” are can help you see breakouts before they happen. For example, look at the chart of the S&P with volume by price overlaid. If you look at the volume profile, you can see that volume drops off at 950. I’m convinced that if we trade above 950 and hold, an explosive move will occur to the upside.

Look at the volume pocket sitting above 950. If we breach 950, there will be a big breakout through the pocket.

It would be much harder to determine this without the aid of volume by price.

To get volume by price on stock charts, go to a normal sharp chart.

Once there, find where it says “overlays”. Click the dropdown and select “Vol by Price”.

Chart away.

Unlike traditional indicators, which are used to supplement traditional candle charts, Heikin-Ashi candlestick charts can be used on their own. You interpret them as you would a candlestick chart, but the open and closing prices are computed differently.

For Heikin-Ashi charts, the opening price is always located at the midpoint of the previous candle. The closing price is equivalent to the average price over the time period. The high and low prices are the same.

The nice thing about Heikin-Ashi candles is that they can tell you how strong a trend is. During a strong uptrend, the candles will remain green, and will remain red in a downtrend. If the candle changes color, it indicates weakness in the trend. This eliminates some of the whipsaw action found in traditional charting.

Here are some general rules of thumb when trading with Heikin-Ashi candles:

• During strong uptrends, look for candles with no lower shadow. During strong downtrends, look for candles without upper shadows. This is a good indication that the buyers or sellers are becoming aggressive!
• When you see a change in color near a support or resistance level, it is usually a good time to exit positions, as the trend may be changing in response to the support/resistance.
• Candles with small bodies and long shadows are also indicators of changing trend. When combined with support/resistance levels, these can be good entry points.
• When the candles move very little during a given time period, it is a good indication that prices are consolidating ahead of another move in the direction of the prevailing trend.

A traditional candle chart is often choppy and can lead to whipsaws.

Heikin-Ashi candles can eliminate some of the choppiness and show trendling behavior more clearly.

Heikin-Ashi candles can be used over any timeframe, but I usually use them for day trading, as they help me get a beat on intraday momentum.

I wouldn’t get too caught up with trying to figure out exactly what they mean. With practice, they will help you to visualize the aggression (or lack thereof) of market participants.

Do not just roll the dice with your trading

Although risk management is not the most sexy aspect of trading, it is certainly one of the most important. It is the first thing I think about before placing any trade, and it’s always at the back of my mind when I’m scanning charts.

But why pay attention to a topic that seems dryer than the desert? Because it could end up saving your account from going extinct.

Don’t Avoid Risk - Manage It

As traders, we take risks every day. Without taking on risk, we would not be able to function. Riskless investments yield very low returns, especially since the Fed has lowered short term rates to near zero.

In order to make higher returns, we have to take on risk. However, excessive risk will get you into serious trouble. The key to placing winning trades often comes down to how you manage your risk, and what potential reward that risk carries.

How much risk you are willing to take on should depend on your timeframe, trading style, and potential reward.

This amount should always be the same, and you should adjust your position size to ensure that. I recommend risking between 1 and 2 percent of your account equity on each trade, especially if you are new to the game. This means you can be wrong as many as 100 times and still have money left (that almost never happens). If you have a small account, and using 1% isn’t quite feasible, you may consider upping that amount to 5-10%.

If 1% of my account is $100, then I would risk no more than $100 on each trade.

Defining Risk and Reward

I define my risk as the difference between my entry point and my stop-loss - and yes, you should always use a stop-loss. Doing this limits your losses at a pre-defined amount. That amount should be how much you are willing to risk on the trade.

Set it too tight, and you may be whipped out of the trade, but set it too loose and you may end up losing too much.

In order to combat that problem, I usually enter trades near areas of support and resistance. For example, if I am looking to buy a stock, I would look to buy it as close to the nearest support level that I could. This allows me to place my stop-loss very close to my entry point, which minimizes risk.

From there, I adjust my position size to match my risk tolerance.

Let’s say there is $1 between my entry point and my stop-loss. I would plan on buying 100 shares. That is my position size.

In terms of reward, that should always be your secondary concern. Obviously, you should never take a trade that doesn’t offer any reward, but as long as you manage risk properly the rewards will tend to take care of themselves.

Reward is defined as the difference between your entry point and your target. You should always try and use a target price, even if it’s only a rough estimate. This will allow you to get an idea of your risk/reward.

Sizing Up Risk/Reward

Before taking a trade, I always look into the ratio between my reward and my risk. If my reward to risk ratio is greater than or equal to 2, I would consider taking the trade.

The better this ratio, the less often you have to be right on trades, so small changes can have a very big impact.

Download the Pro Trader Course Today and Get Free Coaching!

To understand why, you need to look at the relationship between gold and equities. The role that gold plays in intermarket dynamics changes over time. It generally moves opposite to the US dollar, as investors allocate their assets in the stable metal when the fiat currency weakens.

However, lately gold has acted as a hedging device for traders. That is, people are buying gold in order to insure against downturns in the stock market. That makes for an inverse relationship between gold and stocks. When the stock market is down, gold goes up, and vice versa. Of course, this is not a one to one relationship - there are multiple intricacies, but it generally holds true.

If you find yourself trading a market where a rally seems to be fading out - one similar to the one we are in right now - it can be tough.

In times like these, I like to buy gold stocks.

When the market is up, gold equities will rally with the market. When the market is down, gold stocks will hold up well due to their ties with the metal. It’s a win-win situation.

If you want to try your hand at a gold name, here are some of my favorites. Many of these companies are involved in gold mining or distribution. They are influenced both by gold prices, and by stock prices. These are live charts, so you can follow along day by day.

LIHR

At the time of this post, LIHR looks poised for a breakout.

ABX

ABX has already broken out of a bull flag. Look for more continuation.

AUY

AUY has broken out from its recent trading range. Look to buy dips.

IAG

IAG has broken out from a bull flag.

For my complete gold watchlist, click here.

Disclosure: Long IAG

Oooh, shiny!

I think you have to follow the sectors in order to gain an edge right now. I read once that the sector a stock is in controls 50% of the price movement of the individual stock. With that in mind, you want to try and go long stocks in strong sectors and short in weak ones. I keep a list of all the sectors here, where you can look at the charts.

It seems to me that the S&P may be forming a lower high. Depending on how you draw your trendlines, you may consider the upward trend we have witnessed over the last two months to be broken. If that’s true, it will be confirmed if and when we complete this lower high. I’m not saying this bull run is over, but it is certainly showing signs of weakness.

Is the trend finished?

I might be too bearish, but I think we all understand the case for higher prices. After all, it’s hard to fight the trend. However, you need to keep these warning signs in mind when initiating new risk until the S&P is able to definitively continue its trend.

Back to the sector watch, I have noticed that some sectors are also putting in lower highs. That, to me, is a sign to short stocks in those sectors. On the other hand, some sectors appear to be holding up pretty well.

Hot: Consumer Staples, Healthcare, Energy, Materials

Not: Technology, Financials, Consumer Discretionary

Keep your eyes out for an article tonight about gold stocks. Happy Trading!

Stocks failed to make a directional move, and were mixed across the board. The VIX, on the other hand, paints a different picture. Breaking down below 30 today, volatility levels are the lowest they have been since before the panic set in last fall. This indicates that participation in stocks is broad. Fear has been removed from the market.

A VIX of 30 used to be extremely high, but this is a positive development nonetheless. Despite the move in volatility, stocks still couldn’t put together a decent rally. That signals divergence. I’m not really sure how to read into it, whether it be bullish or bearish.

On other fronts, energy continues to rally quietly. Crude oil finished the day better by more than 1%, easily outperforming equities. If you are having a hard time getting a read on stocks, consider playing an energy name to the upside.

The rest of this week should help sort out the murkiness of this market. A little bit of clarity should help to improve trading conditions a great deal. Until that happens, it makes sense to reduce risk and manage existing positions tightly.

Happy Trading

The breakdown in the VIX signals that fear has reached pre-crisis levels.

I’m still a bit skeptical about this sharp rally today, as the longstanding upward trend in the S&P was broken last week. We still haven’t tested 875 to the downside.

Interestingly enough, the market remained on bull confirmed on Friday, despite the selloff. If the S&P trades 875, it will go on a sell signal. This price action will also likely push the $BPNYA into bear alert. 875 also serves as support from a traditional perspective. It’s not guaranteed to give way, but if we do break those levels, we will likely head a lot lower in a short period of time.

The market needs to stay above 875 to avoid a sell signal

On the other hand, the bulls held the line on Friday and came out of the gate strong today. The S&P traded as low as 878, which you could argue constitutes a succesful test of 875. In addition, adjusting the trendline shows that this could be a buyable dip.

I didn’t buy today, but I could easily be wrong. I don’t have a great read on this market and I’m worried that it will make the next move without me. I’ll be keeping my eyes pealed to try and figure out where the market wants to go. It’s likely we could trade sideways all week, too.

Bulls will argue that this trend is intact. Here is what they are looking at.

I don’t know what’s going to happen. I’m open to suggestions if anyone is willing to offer. What do you think?

Yesterday, the $BPSPX went on bear alert - which signals that more downside may be coming. After today, it is likely that the $BPNYA, the bigger picture indicator, will have slipped into bear alert as well. This is coming off of fairly overbought levels. Bullish percent levels haven’t been this high since 2007.

For that reason, I will avoid buying stocks until we produce a new bullish signal. However, I won’t pile on the shorts until we break 875. That should act as a good confirmatory indicator to our bear alert signal.

Just to give you some context, the last time the $BPNYA produced a similar signal, it went on bull alert. That was in March. From there, the S&P rallied nearly 40%. I believe this signal could have similar implications, so be alert.

See you next week.