A Simple Strategy
Stockscores.com Perspectives for the week ending September 1, 2008
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In this week's issue:
Picking good stocks should be very simple, but many traders put a lot of effort in to making it difficult. They believe that their success at making money in the market is based on their ability to pick the right stocks. So, they put a lot of emphasis on how they pick the stock to buy and often forget about the other components of the investment progress.
I think that the great traders and their great trades are based on very simple ideas, strategies that can be explained in one or two sentences. Last year, the best trades were shorts in the financial market. The idea was simple; short financial stocks that loaned money to marginal real estate purchasers.
But there is more to trading than just a simple idea, success is ultimately based on the execution of the idea and the reaction that the trader has when things go against them. I think that traders who focus their efforts on risk management, the exit decision and emotional control would do a lot better than those who focus on what to buy.
Let's consider a simple idea to highlight what I mean. Strong stocks have to go to new highs, right? When we think about the big winner stocks of the last few years, names like Apple (AAPL), Potash (POT) and Google (GOOG) come to mind. Penny stock investors might think of Noront (V.NOT).
All of these stocks have one thing in common. At some point in their upward trends, they hit new all time highs.
So, we can say then that all strong stocks must hit new highs. Does this mean we should buy any stock that hits a new high?
Probably not, for stocks that are reversing in to downward trends are also hitting new highs. What we want are stocks that are starting trends that will continue to make new highs after we buy it, so we need to add in some other criteria to avoid the stocks that have already made big gains and are likely topping out.
How about we look for stocks that are hitting new, all time highs after a period of sideways trading? This way, we focus on stocks that the market is obviously optimistic about but are only just discovering. Since the stocks are hitting new highs, there must be something going on that has investors willing to pay more than they have ever paid for the stock in the past. But, by only considering stocks that are breaking from periods of sideways trading, we eliminate those that have been bid up by emotional speculation.
AAPL did this on April 26, 2007 at $98.84. It eventually hit about $200.
POT did this on Jan 29, 2007 at $51.57. It eventually hit $240.
GOOG did this on June 5, 2007 at $518.84. It went to $747.
V.NOT did this on Sept 10, 2007 at $1.74. It rose to $7.
But what about those times when this strategy does not work? This is where the focus on risk management is so important. As traders we have to expect that we can not be right all of the time and it is what we do when we are wrong that will have a huge influence on our overall results. Avoiding big losses is essential to success, we need to have a means to not only pick the right stock but also pick the right point to declare the trade a failure.
I like to use a concept called inflection points which, simply, is the point where the buyers take control of the stock before the entry signal. For a stock purchase, it is the point where the stock stops going down and starts going up. This point establishes a floor price where the buyers made their stand.
On AAPL, this price was $89.60. This means that an entry at $98.84 had the potential to lose $89.60, possibly more if the stock gapped down through the support price. The risk to the downside was about 9%.
On the AAPL trade, the high was more than 100% more than the purchase price which meant the stock trade could have achieved a 10 to 1 risk reward ratio. However, most traders tend to sell their winners too early and fail to capture good portions of the upward trend. They fail to be adequately rewarded for the risk that they take.
Or, they hang on forever and watch their gains evaporate. AAPL went down to $110 in the two months after it hit $100, potentially taking away all of the gains that it had made from the original entry signal.
This is why it is so important to focus on good exit strategies and the emotional control to stock with winning trades. But again, most people just don't spend a lot of time working on these skills because they think that successful trading revolves around buying the right stock.
Is buying stocks that hit new highs from a period of sideways trading a good strategy? Only exhaustive statistical testing can answer that question for certain, although I expect it is a strategy worth considering. However, what everyone should realize is that it is not the entry decision that determines long term success as a trader. Traders also need to master risk management, the exit decision and their emotions if they are to have any hope of beating the market over the long term.
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This week, I considered stocks that were moving to new highs from lengthy periods of sideways trading. I wanted to find stocks that have been stuck in trading ranges for a long time but are now catching the interest of buyers willing to pay more than anyone has paid before.
I looked at the charts of all the NYSE, NASDAQ and TSX stocks that hit new highs in the last few days and focused on those that are just now breaking through some long term resistance. If they made their first break to new highs in months past and are now in an upward trend, I avoided the stock.
From this strategy, I found three stocks that I think are worth considering. Here they are along with the support price for each. The chart set up has gone negative if the stock closes below support.
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1. DXPE
The pennant pattern on DXPE has been building for two years and the stock has now broken out to new highs. It has been going up for a couple of weeks so I think this stock will be better on a pull back. Support at $49.15.
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2. FAST
FAST made a fresh break on Thursday through resistance that has been tested but never broken. Support at $49.50.
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3. T.PIX
T.PIX has been building an ascending triangle pattern for close to two years. The stock broke through resistance on Wednesday. A pull back in the very short term is likely, but the longer term outlook is good so long as support at $1.35 can hold up
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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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