Elements of the Trade
Stockscores.com Perspectives for the week ending December 7, 2008
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In this week's issue:
Have you ever thought about breaking your trading decision down the way a doctor looks at a problem? Imagine if a doctor made decisions on your health using the same process as you use to make trading decision. I am quite sure that many people make "instinctive" trading decisions that hurt their financial health, so let's consider a series of steps that should be taken in the trading process.
Diagnosis
The first thing you need to do is figure out what the situation is. Are the buyers or sellers in control? You answer that question by looking at the stock chart and whether there are rising bottoms on the chart or falling tops. Rising bottoms means the buyers are in control while falling tops show the sellers are strong. Look at six month time frame to judge the near term sentiment but also look at a two year chart to get a feel for the longer term sentiment.
Have they just taken control or are we nearing the end of their reign? For this, check the two year chart and see how long one side or the other has been in control of the market. Keep in mind that one side could be in control in the relative short term while the other side could be dominant in the longer term. This can set up a good opportunity since the longer term time frame will usually win over the shorter, providing a trading opportunity for someone who times the reversal back in favor of the longer term time frame.
Is the stock trading rationally or emotionally? A rational market will be in a linear trend. An emotional market will be much steeper, more of a curve. Emotional markets usually regress back to the linear trend line, setting up another type of trading opportunity.
Finally, is the stock trading in a way that provides opportunity? Most stocks, most of the time do, not provide a good trading opportunity because they are efficiently priced. However, a great trading opportunity may exist in cases where the market is trading emotionally or where there is important new information coming in to the market.
Prognosis
With diagnosis you can make a prognosis, a telling of what will happen in the future. A stock that has gone up with emotional buying will eventually correct. A stock breaking down from a pessimistic trading pattern will likely go in to a downward trend. Abnormal buying on strong volume out of a period of sideways trading often leads to a strong upward trend.
Verification
Correct Prognosis is only profitable if it is well timed and it is the timing of trade entry that is the most difficult. You can go broke by making the correct diagnosis and prognosis if you don't time the entry correctly. I always look for a trigger to prove my Prognosis correct. If I am considering shorting a stock that has gone up with emotional buying, I want to see a break of the upward trend line as the trigger to take the short. For me to take a trade, the market has to show a little hint that I am right. This means I will get in just slightly late but it also dramatically increases the probability that I am right.
Execution
With Verification comes the cue to execute the trade. With good diagnosis and prognosis, this is a simple matter of completing the transaction. However, with every execution you must also know under what conditions your diagnosis or prognosis has been proven wrong. This is the stop loss point, the price level where the market has told you to exit the trade and go back in to diagnosis mode. You must know your stop loss point at the time you execute the entry for your emotional self will change your interpretation of what the market is telling you once you are in the trade.
Evaluation
As the market evolves and prices change, always evaluate. Remember that the market is not a perfect pricing mechanism, there is a lot of uncertainty and that causes price fluctuations around the general price move. Buying a stock with the correct diagnosis, prognosis and verification does not mean that it will instantly go in to an upward trend and a failure to do so means you were wrong in some way. Expect and accept some deviation from the plan but if the stock goes off course to the point that you have been proven wrong, get out of the trade.
Completion
If everything works out and you make the right trade, the winning trade, then there will come a time when the trade will have played itself out and it is time to exit. The completion is the most difficult step in the process because it requires the patience to wait for the play to develop. You must work to maximize profit when you are right and minimize loss when you are wrong.
Take these trading elements to heart and work through them individually every time you trade. Whether I am doing a day trade to hold for the next 10 minutes or a position trade to hold for the next 10 months, I always break the trade down in to these steps. Actually, there are times when I make mistakes and don't do each step, and when I do, it always seems to cost me money.
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Trading is more about understanding human behavior than it is about understanding Finance. It is humans that decide what to buy and sell and their future decisions are somewhat predictable because human behavior is predictable.
The market went up on Friday despite very bad news on job losses in the US. Anyone who applies logic to the stock market would expect stocks to plummet even more when record numbers of people lose their jobs. But the market does not look backward and logic has no place in stock analysis. The Dow made a 260 point gain after turning around from morning weakness.
I think that there is a good chance we will see continued strength in to Christmas as the market makes a bounce back from prices brought on by irrational selling pressure. This week, I present a few stock picks that require some verification before taking the trade.
I also want to stress that I consider these short term trades, a place where nimble investors can take some quick profits over the next couple of weeks. It is too early in a turn around to consider them long term plays.
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1. T.POT
T.POT (POT on the NYSE) stock is in a price pattern called a Falling Wedge. This means the tops on the chart are falling quicker than the bottoms, forming a wedge shape. It is a pattern that represents sellers that are losing their enthusiasm for selling. When you get to the pointy end of the wedge, you look for a break to the upside and that often leads to an upward move that can be pretty quick. For T.POT to break this pattern and give a buy signal requires that it break the downward trend line that has been in place over the past two months. A move above $75 would achieve that. If that happens this week, consider entry with support at the low of this trend which, as of today, is at $61.80. The prices are for the Canadian listing, the NYSE listing will be lower.
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2. T.RIM
T.RIM (RIMM) is another stock in a falling wedge pattern, all that remains to complete the pattern is a break to the upside from the pointy end of the wedge. For T.RIM, that requires a move above $56 and puts support at about $45. Again, all prices are for the TSX listing, the Nasdaq listing will have prices that are lower because of the difference in currency values.
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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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