Selling Aggressiveness
Stockscores.com Perspectives for the week ending October 14, 2006
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In this week's issue:
How can we balance the need to maximize profits but not give back those profits when the trend reverses? The key is in recognizing emotion in the market and taking a more aggressive approach to selling when emotion is high. Doing so is quite simple; it is all about the slope of the upward trend.
Up trends tend to start slowly, it takes time for investors to believe in the company story and take action. First a breakout of some sort occurs and then usually a pull back as investors show doubt about the validity of the price increase. New investors are attracted by up ticks in the stock and significant fundamental change is often what causes breakouts so the buyers tend to take control of the market after the initial pull back. This takes the stock in to an upward trend.
Upward moves and pullbacks create the upward trend line, drawn along the bottoms of each successive pullback. With these rising bottoms the market establishes the optimistic upward trend chart pattern.
An orderly and relatively unemotional upward trend will be linear. This means that each successive pullback back to the upward trend line can be defined by a straight and upward sloping line. New high, pull back to a low that is higher than the previous and repeat. So goes the upward trend.
The emotion of investors heightens as the trend matures. With higher prices come entry decisions motivated by greed rather than rational analysis. Investors start to take positions because they fear they are missing out on an opportunity if they don't buy. The pace of the upward trend steepens, changing the linear trend in to a parabolic curve.
In an orderly upward trend we look for a break of the upward trend line as a signal to exit the trade. When the trend goes in to a steepening curve we have to get more aggressive to lock in profits. Since emotion is playing a role in the buying decision of investors it is likely that the stock will suffer a sharp correction back to the trend line.
As a result, the Stockscores Approach advises that the trader look for a close of the current candle below the low of a candle that was noticeably taller than those before it. We call these Trigger Candles because they trigger an exit order and use them when the trend is steep and motivated by exuberant buyers.
This approach allows us to maintain a position during the inevitable pull backs that define a long term upward trend but still take advantage of abnormal profits that come from irrational market behavior. We take the less aggressive approach to selling by looking for a break of the upward trend line when the trend is linear and move to the Trigger Candle method when the trend goes parabolic. This often allows us to maximize profits and even re-enter the stock when it comes back to the longer term linear trend line.
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The most important factor affecting stock price is information. As information about the earnings potential of a company is made public, prices move to reflect the new knowledge. Often, stocks move in advance of the public release of information because there are market participants who have access to the information early. In other words, the process of information dissemination is gradual and not always fair.
Fortunately, this process often shows up in market activity. If significant new information is available, those with access to that information at an early stage may buy or sell in the market. In doing so, they can cause abnormal market activity.
For example, if an individual learns that Company A is likely to announce an alliance with Company B that will have significant impact on Company A's bottom line, that individual may decide to purchase shares in Company A. If there are enough people with enough buying power doing this, they can cause the price of Company A to move significantly, and trade an abnormal amount of volume.
Mathematically, we can define what a normal price move for a stock is based on its past trading history. A stock like Microsoft may move up or down 3% on average in a day. A smaller, more speculative stock may have a greater range of price movement. Based on their specific trading history, it is possible to extrapolate an expected range of price movement for the next trading session. If that stock moves outside of that range, it is deemed to have made an abnormal price change.
We can apply the same reasoning to the quantity of stock traded on a particular day as well. If a stock trades far beyond the average number of shares that it has traded historically then, statistically, it has traded an abnormal number of shares. Identifying stocks that make statistically significant abnormal price movements while trading an abnormal quantity of shares provides clues that the stock is trading on significant new information. That information may have been made public, market participants may be making an educated guess on future information, or privileged market participants are trading on private information. In certain situations, stocks that behave abnormally are often telegraphing future price trends.
Identifying stocks that have made statistically significant abnormal price gains is an excellent way to find stocks that may continue into up trends. However, using only this filter is insufficient as you will simply find too many candidates and a success rate for finding winners that is too low.
Recognizing that price volatility defines uncertainty, we also want to focus on stocks that have recently been in a period of low volatility, relative to the past trading history of the stock. Market participants are confident about the value of a company that shows little volatility. In other words, the market is confident about the price it has given to all available information. Therefore, if a stock breaks from this period of low volatility with an abnormal gain, we hypothesize that the move was motivated by new information. This new information will take the stock higher as more people learn about it. If the stock makes this abnormal break out of a period of low volatility with strong volume support, we have even more evidence that there is new information causing some investors to get excited.
The concept of resistance is very important to this strategy. When looking at a stock chart, it is relatively easy to see that there are price ceilings that seem to prevent a stock from moving upward. In our previous example, that ceiling was at about $12. This line of resistance is really just a boundary above which the market is unwilling to pay. Based on all the information that the market has about a company, the market is unwilling to pay more than the resistance price.
Therefore, if a stock breaks above resistance, it may imply that there is new information that makes the company worth more, and therefore, the market is prepared to pay more. Therefore, the logic of this strategy is as follows. Identify stocks that are behaving abnormally to the upside and trading abnormal amounts of volume because that is an indication that there is something positive happening. If the stock is moving from a period of low volatility, we can assume that the market was confident about the valuation it has given the stock. Further evidence of new information is found if the stock breaks from this period of low volatility and above a line of resistance to prices beyond which the market was previously unwilling to pay.
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1. VTSS
VTSS breaks through short term resistance after breaking its downward trend line a couple of months ago. Volume and price action was abnormal Friday as the stock breaks from an optimistic pattern of rising bottoms. Support at $0.99.
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References
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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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