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cycle that stocks go through.
First, there is the breakout cycle, where typically savvy traders, and some lucky traders, latch on
to a hot story early and break the stock from a trading range and begin its abnormal trading
activity.
Next, there is a quick pull back as owners of the stock, who are not aware of what is causing the
breakout, sell in to the strength as they consider themselves lucky for getting out a higher price.
What is critical in this stage is to see whether the stock penetrates support, or if the first group is
able to hold back the selling force and maintain its technical strength.
The next stage is the critical one. If there is good justification for the breakout, then the bigger
money momentum players will come in to the stock and give it a surge upward to new highs, with
heavy volumes. Initial selling pressure abates and the stock can often surge dramatically higher.
Along the way there will be short pullbacks as groups of traders nervously take profits. These are
shake-out phases that can be difficult to separate from the stock truly topping out.
Finally, there is the exhaustion phase, when emotional traders enter late but the big money clears
out their positions. There is often very strong volume, but upward momentum slows. The peak is
typically marked by a pullback, and rally that fails to make a new high and then a breakdown from
a falling top. The party is over.
So, where do the Pros make money and the Rookies give it up? Pros may buy in to the breakout,
but instead of getting out nervously on the post breakout pullback, they actually add to their
positions. Unless support is violated, the stock has good potential to go higher.
As the stock moves upward, the Pro may anticipate where the stock will find some resistance and
sell in to that price point, with the aim of getting back in at lower prices on the next pull back
phase. Rookies buy the stock as it approaches resistance, and then get shaken out when the
stock pulls back sharply on emotional selling.
Finally, Pros will liquidate most of their position through the major upward phase while the general
public buys. Pros look to short the stock when the greenest of the Rookies is buying in to the
exciting up trend. When the stock breaks down from a falling top, the Pro is short while the
Rookie is hoping for a turnaround.
Human beings are programmed to fail in the stock market. From our childhood, we are taught to
avoid pain (don't touch that, it is hot!) and seek out pleasure (if you are good, you can have some
ice cream). Stock traders have to spend a lot of time reprogramming to buy weakness in strong
stocks, and sell strength in weak stocks. That means seeking pain, and avoiding pleasure, a very
hard thing to do.
This week, I want to talk about the Risk/Reward trade off, and why understanding it is so
important to successful investing and trading. Most traders are concerned with when to enter a
stock, and neglect understanding the appropriate position size and profit potential of the trade.
When considering a trade, it is important to establish a loss limit. You can not be right on every
trade, but limiting losses when you are wrong will improve your long term performance. When
buying a stock, plan to sell if it moves below support. When shorting a stock, plan to cover the
short when it moves through resistance.
The difference between the entry price and your stop loss price represents the basic risk of the
trade. If you are buying a stock at $10, and will take a loss if it moves to $9, then you have a risk
per share of $1. If you don't want to lose more than $500 on the trade, then your position size
should be 500 shares (this is a simple example, we should also factor in commissions and
slippage).
When looking at the stock chart, we should also consider what the potential gain on the position
is. If we are buying a stock at $10, but the stock will encounter technical resistance at $11, then
we only have $1 of upside. If the stop loss point is at $9, then we have the same upside potential
as downside potential. That makes the risk reward trade of 1:1.
When trading, I have found that it is better to have a 1:2 or better risk reward ratio. That would
mean that we would not take the trade at $10 unless we saw good potential for it to move to $12.
You can take trades that have less than a 1:2 risk reward trade off if the probability of success is
very high (70% or better). You can also take low probability trades if the risk reward ratio is very
high.
When you find a good stock chart, you should then consider the position size based on the entry
price and stop loss point. Then, consider the likely upside potential of the trade, and calculate the
risk reward ratio. If the trade has a good probability of success, and the profit potential is two
times or better the loss potential, then the trade is worth considering. A good chart that does not
have enough upside potential to compensate for the downside risk is not worth doing unless there
is a very high probability of success.
Good traders are more than good stock pickers, they also practice good risk management,
limiting losses when they are wrong and letting profits run when they are right.
Bottom fishing is the quest for stocks that are inexpensive relative to previous levels, but show
signs that the bargain is going to end soon. We want to look for stocks that are a showing a break [ Pobierz całość w formacie PDF ]