Possibility or Probability?
Stockscores.com Perspectives for the week ending May 13, 2005
In this week's issue:
There are a lot of things that are possible. It is possible to make money buying stocks in downtrends. It is possible to draw a four when you have 17 in Blackjack. You might find a rare work of art in a garage sale. Maybe you will inherit a million dollars from a relative that you have never heard of.
All of these things are possible, but are they probable?
To make money in the market, you have to ignore possibilities and focus on probabilities. The economics of probability theory are essential calculations that all investors must consider before making any investment or trade.
For example, suppose you find a stock breaking out from a very nice ascending triangle pattern. From experience, you know that this pattern set up has a 70% chance of leading in to a profitable up trend without penetrating support. Based on probability, this is a good trade.
However, when you analyze the trade more closely, you see that the stock will likely find resistance at $20, and it is currently trading at $18. Support is at $14.00, so you have $4.00 of downside risk for $2 of upside potential. Since you have a 30% chance of losing $4 and a 70% change of gaining $2, the expected out come of this trade is $0.20 (0.7 * $2 - 0.30 * $4). That hardly makes the trade worth it, so even though you will probably be right, the economics of the trade do not make it worth making.
Do you make these calculations when making a trade?
Picking the right stock is only a small component to finding success in the stock market. Effective risk management is even more important, and can be the difference that makes an average stock picker in to a profitable trader. I have met great stock pickers who could not make money because they did not manage risk effectively.
As stock pickers, one of the most difficult things to do is differentiate between what might happen and what will probably happen. Our emotions can get the better of us, causing us to focus on what might happen. Why do people buy lottery tickets? Despite the horrendous odds against winning, many people buy in to the long shot dream of fast millions.
I have heard so many stories about stocks that might hit it big on some business prospect that they were working on, and yet the charts showed that there was very little chance of that happening. Yet, because every once in a while one of those companies does succeed, people still buy in to these weak stocks. There are stock promoters living in expensive houses all over the world because they were able to convince some investors that what might happen could happen, even though it probably would not.
For every trade that you are considering, examine the probability of a profit versus a loss and then assess the economics of the risk. What is the upside potential? What is the downside potential? What are the probabilities for each? If these numbers don't indicate a good trade, then it is probably best to look for something better.
Back To Top
Stocks go up in price because investors are willing to pay more. Investors tend to buy companies that they are optimistic about, so it is important to measure whether investors are generally optimistic or pessimistic about a company. Stock charts can provide many clues about the mood of the market. For example, rising bottoms on a stock chart indicate greater enthusiasm among buyers than sellers.
The Sentiment Stockscore considers these kinds of chart pattern factors, and provides an indication of whether investors are showing optimism or pessimism. I have found that stocks that have a Sentiment Stockscore moving through 60 and rising tend to continue to rise as investor optimism carries them along.
The Sentiment Crossover Market Scan seeks stocks that have their Sentiment Stockscore crossing in to the 60 and greater zone after a lengthy period below 60. If this occurs, and the stock does not have significant overhead resistance, then there is a good potential for a future uptrend. By limiting downside potential with a stop loss point just below a short term support price, investors can better manage risk while leaving the potential for price gains.
This strategy is good for identifying longer term trades that do not require constant monitoring. The criteria are relatively simple, and a regular check of positions for an exit signal may only take a few minutes.
Back To Top
1. MOT
MOT is breaking from an optimistic rising bottom pattern after breaking its downtrend in April. The stock traded strong volume, and is part of the strengthening Communications Technology sector (.DJUSCT). This stock looks like it can reverse its downward trend so long as it can hold support at $15.50.
Back To Top
References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
Back To Top
|
If you wish to unsubscribe from the Stockscores Perspectives Weekend Edition or change the format of email you are receiving please login to your Stockscores account. Copyright 2004 Market Perspectives Inc.
|
|
