Let Risk Reward Guide Your Trades
Stockscores.com Perspectives for the week ending February 10, 2008
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In this week's issue:
If I told you that my stock picks were right 70% of the time and that I only lost money 3 out of 10 times, would you think that I was making money in the market? Most traders would love to have that kind of accuracy and assume that it ensures consistent profitability. But beyond stock picking prowess, there is another factor that is more important to determining long term trading success.
How much you make when you are right and how much you lose when you are wrong is key.
Consider the numbers. A trader that makes an average gain of $1000 when he is right and then loses $7000 a trade when he is wrong has to be right 88% of the time to make money. While it is very difficult to be right that often, it is not hard to have that lopsided of a gain/loss ratio.
The reason is simple. As human beings, we are programmed to let losses grow bigger over time and sell our winners early. If you are a normal human being, you are wired to fail in the stock market.
To be a great trader, you have to think differently about risk.
The best traders I know are those who don't care if they lose money. They don't judge their market performance one trade at a time. They don't let small losses grow in to big losses. They add to their winners. They ride a strong stock until it has shown important signs of topping out.
What do you do?
If you are like 90% of investors, you don't plan your losses and instead hold on to a weak stock way too long with the hope that it will turn around. Hope turns traders in to long term investors. Hope belongs in the bedroom, not in the stock market.
If you are like 90% of investors, you sell your profitable trades at the first sign of weakness. You may even sell them before they show weakness because you love to rejoice in the feeling of making a profit. You worry about your winner turning in to a loser and are afraid of the pain that you feel when this happens.
It all comes down to pleasure and pain. These two words are why most people have trouble beating the stock market. If you want to be a great trader, you have to reverse your mental associations to them. If you do, then making money is easy.
I have met many traders who tell me that they would make money if they only shorted when the bought or bought when they shorted. The truth is, reversing the position is not enough to reverse your fortunes. The reason is simple; it is not the stock pick that determines your success, it is how you react to seeing a loss or a gain. It is what you do after you enter the trade that matters.
Some simple rules:
Never add to a loser
Plan your stop loss points
Execute your exit when the stock hits your stop loss point
Don't take more risk than you are comfortable with
Don't watch the profit/loss figure, watch the chart
Be prepared to ride out short term pullbacks in long term trends
Sell when there is a reversal signal, not when it feels good
Be selective about what you trade
These are simple rules that are hard to follow because of the eight inches between your ears. If you can keep your emotions in check then you can trade well. If not, go to Las Vegas. At least there they give you free drinks.
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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. V.PRB
I would not consider this a really high probability trade but if it does work it should give a high multiple of reward to risk. V.PRB has been quiet for a few months and basing nicely after a sharp run higher in September. The stock started to show some life on Friday and it looks like the buyers are trying to take control of the stock again. If the stock falls below $0.62, consider it a dud. But if it works, we could see a run up toward $1.50.
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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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