the cardinal rule
Last week I mentioned that for you and me trading–as opposed to investing–should only be for a small portion of our portfolios.
Our biggest, perhaps only, advantage over professional investors comes from knowing a few things better than most other people and in being able to adopt a longer time horizon than pros who are worried about quarterly performance.
When we decide to trade, we give up those advantages. The main reasons for doing so are that we’re currently in a period of unusually high volatility and because we can probably find one or two stocks to study to the point that we know the short-term movement patterns as well as anyone else. Having something to do to fill up the day is a far distant third reason to trade.
finding a stock to trade
fundamentals should be at least stable
Our idea is going to be to buy and a low point, sell at a high point and then repeat. We don’t want to be involved with a stock where the business of the underlying company is deteriorating, because this diminishes the chances of the stock ever going up.
When we find a candidate, the first thing to do is to get a chart of the stock price over the past several years. On it, make one line that goes through all the short-term high points, and a second that goes through all the lows. This will typically form what technicians call a channel , within which the stock will trade and whose upper and lower walls will mark turning points between which the stock will bounce. The move from lower wall to higher wall and back could take a month or it could take six. The assumption we make, as the basis for our trading, is that this pattern will recur. Buy at the bottom, sell at the top, and repeat.
Channels can either consist of two horizontal lines or have an upward or a downward slope. In my experience, the chances of a breakout to the downside are much higher if the channel has a downward slope. Avoid downward sloping channels.
ranges don’t last forever…
…although a given stock can trade in a well-defined channel for years and years. So we have to be alert for a breakout from the channel, either to the upside or the downside. Upside breakouts are little more than an eventual fact of life for traders, and a key reason not to try to trade the entire position in a core holding. Downside breakdowns are a greater practical concern. Finding companies to trade that have strong fundamentals and are in uptrending channels is our best defense against this.
make a plan in advance: (my) rule of thirds…
If we’re going to try to trade a stock that has shown a past pattern of trading between 10 and 20, there’s no need to buy/sell at precisely the presumed high/low and all at once. My personal preference would be to buy a third of my intended position at 12, another third at 11 and the final third at 10 (assuming the stock cooperates). I would plan to sell a third each at 18, 19 and 20.
…and stick to it
We all tend to get caught up in the moment. At least I do. Let’s say the plan is buy at 12, 11 and 10–and sell at 18, 19, 20. If the stock drops to 9, don’t buy more. If the stock gets to 19.5, don’t decide to hold out for 25. Sell at 20.
trading is not for everyone
I find it entertaining. But it can be time-consuming. Some people have a knack for it, some don’t. Remember, too, that trading can be a bit like bowling or golf. Other peoples’ public success stories are most likely not true and complete.