Interactive Investor

Chart of the week: Royal Bank of Scotland - ideal trade at low risk

26th January 2015 10:54

John Burford from interactive investor

By John C Burford, author of Tramline Trading, and editor of MoneyWeek Trader

In these weekly articles, I will highlight a share that I believe has an interesting chart pattern. I am primarily a technical trader and use the methods I have developed that I call Tramline Trading. You can read more about my methods in my book Tramline Trading, which you can inspect here.

Most traders and investors make classic errors by chasing a stock near a top and then hang on to it too long during the decline. You will vastly improve your performance by timing your entries and exits more expertly - and that is what I hope to help you with.

My goal in these articles is to cover a share that has an interesting chart. I I developed my tramline system over several years to give me a set of rules which can provide me with trade entries at low risk. The low risk requirement was crucially important because no matter how firmly I believe in my trade, I could be wrong! And I wanted my wrong trades to hand me the smallest possible loss to my account. I figured the winners would take care of themselves.

My hope is that you glean useful ideas and employ at least some technical analysis to bolster your returns. In trading as well as investing, timing is a key factor in your eventual returns.

Has RBS turned the corner?

The UK banking industry has had a torrid time in recent months. Following the credit crunch, the banks were bailed out by the taxpayer ostensibly to prevent a total collapse of the banking and financial system. Now, RBS is majority taxpayer-owned.

But since then, a veritable laundry list of scandals has been uncovered in UK banks. The biggest consumer fraud in UK history is the Personal Payment Protection (PPI) scam. UK banks have been paying out billions in compensation with no end in sight.

Then there was the LIBOR rigging fiasco in which Barclays was one of the main participants.

And then followed the interest rate swaps scandal which ensnared many small businesses.

So no wonder the banks suffer very poor ratings for customer satisfaction - perhaps lower even than financial journalists!

But what about the underlying business? The markets take a very pragmatic view of the above negatives and reckon that if they can be contained, the shares remain in play.

Reading the charts

As a technical trader, I read the price charts to gather clues as to the most likely direction the market will take keeping one eye on overall market conditions.

To start, I need first to scan the chart of the banking sector as a whole. Luckily, the US markets have a multitude of indexes of defined sectors. One of them is the S&P Bank Index.

This is the index of the banking shares which are contained in the S&P Total Market Index. And because the major US and UK banks are international in scope, the performance of UK and US banking shares will not deviate very far from each other for very long. Essentially, they all compete for the same business of M&A fees, loans and sovereign bonds.

In addition, banking shares traditionally have performed with the economy - when times are good, banking shares do well, and vice versa.

Banking shares lead in a downturn

But there is one stand-out feature of banking shares I have noted over the years. It is this: when the economy is about to take a dive, banking shares are always out in front as the canary in the coal mine.

I put this down to a reversal in credit growth - and hence liquidity - that is noticed first in the banks and only later in industry and the public.

And there is one new major headwind for the banks - the collapse in the oil price. Many junk bank loans have been extended to shale oil companies when oil was trading over $100. With the price well under $50, these loans are in very great jeopardy.

So it will be highly instructive to compare the charts of the banking sector with the general market.

This is the daily chart of the banking index going back to last summer:

Very roughly, this index has followed the major stock indexes such as the Dow Jones Industrials and the S&P 500 - until recently. Note that the 200-day moving average (red line) - which many technicians follow - has been broken in recent days and is now turning down.

Now let's compare this weak performance with the general market:

This is the S&P 500 index and both charts made their highs in late December, but since then, the S&P 500 has hugely out-performed the banking index - so much so that the 200-day MA has not been in danger of being broken.

Banking shares are diverging

Note that the two charts are more or less in synch up to the late December highs, but now are diverging markedly.

What is my take on this? It is clear that one of them is wrong! The consensus of money managers is for the S&P to experience another up year. In a recent poll, not one voted for a negative year in 2015.

So with this universally bullish view, odds are very high that we will actually have a down year - and it could be big.

Back to RBS - how is this chart shaping up? Here is the daily chart:

Despite the "spikiness" of this chart, I am able to draw in an impressive tramline pair (see text, pp22-26, 48-52). My upper tramline sports three accurate Prior Pivot Points (PPP, see text, pp 52-53) and three accurate touch points with a pigtail.

My lower tramline is my best fit given the pigtail overshoots.

So for about a year, the market has been trading inside the trading channel outlined by my tramlines. This is important information.

My tramline held!

But the main point is this: in December as the market was hitting the 400p level, it met the solid resistance provided by the upper tramline - and then bounced down off it. The line held.

That demonstrates the awesome power of tramlines. You can project them into the future to give you clear lines of support or resistance. When the market approaches this projection, those are excellent trade entry points. In fact, a short trade at the 400 level was the ideal trade - reinforced by the negative momentum divergence at the top (red bars).

But for now, the major trend remains up (up-sloping tramlines), but the short-term trend is down.

So what can the short-term chart reveal? Plenty! Here is the hourly:

The recent rally is in a clear five waves with a long and strong third wave and a negative momentum divergence at the final high - which rather conveniently met the lovely downtrend line drawn off the December 400 high! Friday’s high was the ideal short trade at low risk.

So now, this is shaping up to be classic set-up!

Outlook

Provided Friday's high can hold, the short-term trend is down. A test of support at the 360 area should be very interesting. And if my lower tramline in the daily chart can be broken, it will be on to test support at the 280 area.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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