Scaling Your Fish
Stockscores.com Perspectives for the week ending December 9, 2005
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In this week's issue:
There are a number of dimensions to the stock market success equation. Most investors focus on the stock component, aspiring to pick the right stock as often as they can. While this is important, it is also important to understand the risk-reward component. Someone who consistently picks the right stock can still lose money overall if their losers outweigh their winners.
You can improve the risk reward aspect of the trade with what you do after you enter a position. Adding to profitable positions can improve the profitability of the winners, giving a higher reward to risk ratio. This practice of scaling in to a trending position can make even a bad stock picker very profitable.
Think about trading the stock market like fishing. You cast your line and see if you get a bite. When the fish aren't biting you accept that the area you are working is not good and move on to find a better spot. Then you get a catch and reel in a big fish. Now, do you leave for somewhere else or do you cast your line again? Of course, you stick with where you have proven success. That spot may generate so many fish that you never want to leave.
Scaling in to a stock position requires that you add to your initial position as it becomes profitable. Each time there is a chart pattern set up, a comeback from weakness, you add more to the position. Since the stock is moving up through this process, you also move up your stop loss order so that your overall risk on the trade is not higher despite the large position you are accumulating.
There is a simple rule that you must keep in mind; never add to a losing position. You only buy more stock (or short more if you are in a short position) if the previous position you took is profitable. Add to the position when the market proves you right.
You can do this process with any style of trading. The longer term position trader may scale in to a stock over a number of weeks, the day trader may do so by adding to a position over an hour and let it ride in to the close. What is essential is not the time frame that you scale, but rather, the discipline that you execute the trade with. Because you are building a large position over time, it is absolutely essential to be disciplined when the trade starts to work against you. Failure to do so can turn a profitable position in to a big loser.
In my own trading today, I scaled in to a stock and had some good success. To understand this process it will be very helpful to take a look at a two minute chart of today's trading. You can see that at Bigcharts.com or Prophet.net.
I first entered the trade on NeoMagic (NMGC) at 9:44 ET at $7.49 using my Hitting in to the Gap strategy. At that time, I set my stop at $6.79 which was just below the low of the day. My initial position was 2000 shares, meaning I had $1400 in risk to open the position.
The stock went up briefly and then the sellers took control, something that is pretty normal when a stock gaps up as much as this stock did. However, at 10:28 the buyers took back control and broke the flag pattern that was forming, so I bought another 1000 shares at $7.70. I also moved my stop up to $7.39 giving my position an overall risk of about $510. I now had a bigger position but less risk.
The stock stalled for two minutes and then pushed to a new high for the day so I bought 1000 shares at $7.94. I kept my stop where it was, but this new position increased my risk to $1060.
That jump in price put the stock in to a consolidation phase that lasted about an hour but I was happy to see it as this basing process is healthy and provides a base for the stock to move off of later. At 11:20, I got what I was waiting for as the stock broke out of the consolidation so I took another 1000 shares at $8.07. I moved my stop up to $7.79 which put my overall trade in a profitable position. My risk was gone and I was only waiting to see the upside develop with a larger position that I originally had.
At 11:54 I saw a short term trendline breakdown, so I began to scale out of the position, selling 2000 shares. 10 minutes later there was a break lower from a falling top pattern on the two minute chart, so I sold another 3000 shares. I was not completely out of my position but willing to get back in if a pull back did not develop.
At 12:18 the market gave another entry signal on a flag breakout so I took a 2000 share position at $8.43. It looked like the stock wanted to go some more.
And go is what it did, moving up through $9.50 on very strong volume before a bursting bubble candle (a concept taught in our StockSchool course) came at 13:12. I sold my 2000 shares at $9.53, pennies off of the high of the day.
On this stock I was able to bank about $5,000 in profit which made was about a 1:3.6 risk reward ratio. If I had only stuck with the original 2000 share position that was sold on the first sell signal, I would have netted a $1660 profit and a 1:1.2 risk reward ratio. You can see how working a strong stock by scaling in and out generated a much better return for the risk.
This is a more advanced trading concept that may be difficult to understand, but take the time to learn the art of scaling as it can have a dramatic effect on our long term profitability in trading.
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A common theme among Head and Shoulder Bottom, Ascending Triangles, Pennants and Rectangle Consolidation patterns is a break through resistance from low price volatility, usually with volume supporting the breakout. Rising price bottom formations in to the breakout point are common, but what market dynamic do these patterns really represent?
Rising bottoms are a sign of growing optimism among investors. As time passes, they demonstrate a weakening of selling force and increase power among buyers. As a stock moves up toward a resistance price point, the market is faced with the upper limit on what investors believe the company to be worth. We often see that stocks will go in to narrow trading ranges under resistance as investors come to a consensus on the value of the company. When stocks break out from this condition, they may be signaling significant new fundamental information at work in the market since resistance has been broken from strong consensus out of a period of optimism.
The Sentiment Stockscore is useful for finding optimism in the market, and the Signal Stockscore is heavily weighted on the abnormal market activity that comes with breakouts. By looking for stocks that have a Sentiment Stockscore of 60 or higher, and a Signal Stockscore of 80 or higher, we can consider charts that may have a good chart pattern set up. The Stockscores Simple Market Scan adds in some other technical filters to shorten the list of potential candidates further.
This strategy is not solely about finding stocks with good Stockscores. The most important step is visually inspecting the charts to ensure that the chart patterns are what we are looking for. A good chart pattern will have the following characteristics:
A break through resistance
Abnormal activity, in terms of price and volume activity
The break through resistance should be from a period of low price volatility. Low price volatility is characterized by the price range of trading on each day (how tall the trading range is on the chart) and by the range of trading over a number of days (are the trading days side by side on the chart, or is there a price trend?)
A show of optimism leading in to the break through resistance from low price volatility.
It is necessary to have all of these criteria, many traders forget to check whether the stock was trading with low price volatility before the breakout, or to make sure that the stock is truly breaking through resistance and will not encounter more selling pressure soon.
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1. MXWL
MXWL is breaking through resistance at $15 with an increase in volume. There is some resistance from early in 2004 at $17.50 but I don't think it will be significant. The stock has support at $14.40.
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2. CHUX
The big jump in volume is what caught my interest on CHUX today as the stock sneaks through resistance. I think $18 is a reasonable target over the next couple of months with support at $14.50.
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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.
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