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M.A. Nystrom

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M.A. Nystrom is a private investor and consultant currently living near Boston. He earned his MBA from the University of Washington with a specialty in…

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Home, Home in the Range - Trading the Dow's Inevitable Breakout

Lately I've been getting a lot of inquiries from friends, acquaintances and flat out strangers about how to make money trading. And it's no wonder. Times are tough and people need extra money. Further, everyone knows that commodities are booming and the dollar is crashing. People know that other people out there are making big money on these moves, and they want to get in on the action. They're wondering, "How can I make some easy money trading?"

The great trader Jesse Livermore got this question plenty, and it always annoyed him. Trading was his professional vocation, something that he put much time, effort and study into. Trading was serious business, so he thought the question was akin to asking a medical doctor, "Hey doc, how can I make some quick money doing surgery?" Which is to say that there is no way to make easy money trading. It takes hard work, discipline and study. Most people, it seems, simply want tips on buying what is hot. They want to hear about how much money they can make buying gold and oil. They want excitement.

No doubt, the gold and oil trades are profitable -- if you've been in them for a while. The trick to making the good money is to get in on the trend early. Now that gold and oil are going up like rockets, the timing simply isn't fortuitous for newcomers to get in on the action for short term trades. These markets are going parabolic, and parabolic rises tend to be followed by parabolic declines. The trick to making big money trading is to get in on the trends early, ride them for a long time, and sell out to the newbies, just as they're going parabolic. Dig?

So lets leave the excitement of commodities behind and take a look at the boring old Dow:

Note: The following is not investment advice and is provided for entertainment purposes only. Any trades you make on this strategy are your responsibility alone.

You can see that the Dow basically topped out in early October just above 14,000. It declined to an intraday low of 11,634 on January 22. Since then, it has traded in a range between 12,000 and 12,800. This is clear for everyone to see -- they even talk about it on TV. However, the market can't stay in this little band forever. There are huge macroeconomic and other forces at work in the world. We see these forces pushing gold, agricultural commodities and the dollar into monster moves. These same forces are likely to get to work on the Dow any time now and start pushing it one way or the other. And once that ball gets rolling, the trend should keep moving. The trick is getting in on it early.

The question is, which way will the Dow break? Will it go down, because the economy is headed toward recession and business is going to be terrible, causing profits to suffer? Or is it that the international stocks that compose the Dow will go parabolic like gold and oil as the dollar crashes? What will the Fed's impact on the Dow be? Will the dollar keep falling? We could muse about these topics and more all day long (and on CNBC, they do - ad nauseam). But regardless of what conclusions we come to, the market will have the final say.

If you want to make some easy money trading here is one potential strategy: Watch the Dow. If it breaks above 12,800, buy! If it falls below 12,000, sell! It used to be hard for small "investors" like us to buy or sell the entire market, but there are now all kinds of ETFs that make it very easy. To go long the market, buy the Diamonds (DIA). To go short, buy the Proshares short Dow ETF (DOG). (While you're at it, check out Proshares to see what other kinds of entire markets you can go long and short. You can even go double long, or double short if you so desire. The list is impressive.)

So there is your exceedingly simple plan to make some easy money in the market: Get on the trend in the right direction as described above, and keep on riding it. If you want to end on an optimistic note, stop reading here, and good luck!

The problem, sadly, is that it just isn't that easy. Given this very simple plan, most people still won't make money, because they won't follow the plan. They already think they know what the market is going to do. How could the market possibly rally with this terrible economy, they think. This is the shorting opportunity of a lifetime! Short it now and go in big, fully margined! Believe me, I've been there and done that, and it is no fun when the market decides not to cooperate.

Another way of not following the plan is getting tired of watching the market trade back and forth so predictably in the range. You want some action and you think you can pick up some quick money while you're waiting for the breakout, so you decide to try to play the range itself. The market reaches the bottom of the range, and since you know it is going back up to the top, you buy it. Only to find out that this, finally, is when the market breaks. This is what you've been waiting for! And inexplicably, you're on the wrong side of the trade! Horror of horrors! How did it happen?! Yes, I've been there and done that too and this is no fun either.

Even if you should be able to follow the plan, the Market has an infinite way of fooling people. How much of a breakout is a real break out? What should you do if it looks like a breakout, you commit to your position, but then it comes back into the range? Furthermore, how do you know when you should take your profit? These are all things to think about before you put the trade on. The answers to these questions require a certain amount of wisdom, which results from experience.

If you're interested in acquiring some wisdom on someone else's dime, I invite you to follow along. Think of this market the same way as you think of a baseball game. Most of the time nothing happens. But suddenly, in short bursts, there can be a flurry of activity. The past few weeks have been one of those periods when nothing happens with the Dow. It has been up and down big but with no net progress either way.

But I expect fireworks shortly. The big employment report comes out this Friday (3/7/2008). This report, released the first Friday of each month, has a tendency to move markets big, one way or the other. A week and a half later is the FOMC meeting (3/18/2008) at which the Fed will announce its interest rate policy. Either of these events could trigger some increased activity that will push the market out of its range. Whichever way the market breaks, you should look to get on board. If the market still can't make up its mind, the first quarter ends this month (3/31/08), and companies will start releasing their earnings in April. We'll get a good idea from the firms as to whether the slowdown is real, or whether the Fed's interest rate cuts are helping to revive the economy.

Like any good baseball game, you need to stay tuned with at least one eye on what is going on, and ready to act! It might not be as exciting as watching gold & oil run through the roof, but action in the Dow could happen at any time, without notice, and could be dramatic. I'll write the next update should anything develop. Thanks for tuning in!

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