Successful investors know that if they follow a disciplined investing process they increase the probabilities of success. By following a set of rules to buy and then sell your stock or ETF, you change the odds in your favor.
Disciplined investing is the fourth step in our stock market strategy that we use to beat the market.
The disciplined investing creates the parameters to buy and sell the high potential stocks that were identified when you selected the best stocks to own. The objective is to identify the rules to buy (or short) stock, set your exit target and define the trailing stop.
Technical analysis provides the best way to establish these stock buying rules. Many people believe that being able to properly read and interpret a chart leads to profitable trades. Unfortunately, this is not true. Reading a chart to identify the existing patterns, highlight the important trends and interpret what the indicators mean is only part of the process. The secret is to use the technical signs on the chart to develop the rules of when and where to buy the chosen stock. After all, you are preparing to commit your hard earned money, so you want to be as sure the trade criteria is the best it can be.
Before entering a trade it is important to have a clear plan of where you want to enter the trade, where you will have your initial stop loss, and where you expect to exit the position. There are many ways to use technical analysis, however, most professionals use one these two stock buying rules to time their trades.
The first method is to enter the trade on a breakout through resistance that is accompanied by above average volume. The theory is there must be above average volume to power the stock up through the resistance level. New buying must overcome the investors who are using the resistance level as their sell signal. this method assumes the market is trending up.
If the market trend is down then the rule is to go short when the price breaks down through support. The failure of support might or might not be accompanied by higher volume, as prices can fall without volume to support them.
The second method is to wait for a pullback to a support level. If the price seems to hold this support level or rebounds up from there, it is a good indication to buy.
Our preferred method is to look for support levels to help identify a good entry price. During good times when the market is trending up and the economy is in Early Recovery or Full Recovery stage, buying at or near support is a low risk strategy. Often called buying on the dip, this stock buying rule gives you the opportunity to participate in the up trend of the market and buy at a brief pull back in the price.
On the other hand, when the market is trending flat or down or the economy is in Early Recession or Full Recession stage, you definitely want to wait until the support level is hit and holds before finalizing the entry price. Moreover, it is best to wait for a short term up trend to begin and the right entry set up to show itself. During these times patience is key. Trading just to trade will lead to losses.
Another stock buying rule is to only go with the trend of the market and the sector. It rarely pays to go against the market or the economy. When the market is in an overall up trend and it enters a short term pull back due to overbought conditions, use this opportunity to sell shares of underperformers and buy more promising companies. However, if the market is trending flat or down or the economy is entering or near Early Recession or in Full Recession, it is time to close long positions and either hold cash or start shorting. A very good way to short the market is with ETFs that try to match either 100% or 200% of the inverse performance of a key index such as the DJIA, S&P 500, the NASDAQ 100 and the Russell 2000. There are sector ETFs that short the sector that also work quite well. Most of these are short ETFs are liquid investments that are easy to buy and sell.
Which are the best stock buying rules to use? Well like so many things, it depends on what the chart formation and indicators offer you. In addition, you need to consider the overall market trend; is the market beginning another up leg or is it near a potential top. Where are the best stop and target exits, how long should you hold the position, and, most important, what is the risk reward for the potential trade?
Let's examine some sample stock buy rules to get an idea how to plan the trade. Keep in mind that there might be more than one entry strategy that presents itself. That is just fine and can be quite useful as the trade is planned.
T. J., our industrious investor, has read and studied Thomas N. Bulkowski's book, Encyclopedia of Chart Patterns (Wiley Trading). Late November 2004, he believed that CRZO met his stock selection criteria based on the fundamentals. Moreover, the market was trending up. He complied the chart for Carrizo Oil & Gas, Inc. (CRZO) you see below. T.J. had observed that the overall market was in a secular bull market and that the price of oil was trending up.
He noted that there was resistance (the high reached the week of 6/21/2004) at 10.87. In October, the price hit a high of 10.50, and there was an underlying up trend that began April 2003 with average volume increasing. He knew that this pattern is called an ascending triangle. Ascending triangles represent market supply and demand forces of a stock that is building support through the uptrend and encountering resistance at the horizontal line. Looking at CRZO T.J. noted that retreats toward the lower uptrend encountered buyers who think this is a good buy causing the price to go up. As it approaches the resistance line sellers who have been in the stock from earlier positions close out some of their positions causing the stock to stop rising.
T.J. knows that a break out (the stock moves above 10.87 with above average volume) will only occur if there is sufficient buying volume to move the stock up. So he created an alert in his stock trading system that would warn him when this stock price reached 10.50 (.37 below break out). T.J. also entered an alert for CRZO on the down side after noting that in addition to the uptrend, the 200 daily Moving Average seemed to act as support as well. He chose 9.8 as that alert price. The 200 period Moving Average is also an important indicator or the trend for the period being evaluated. If the MA is pointing up then the trend is up. Conversely, if the 200 MA is pointing down then the trend is down. More importantly, if the 200 MA is transitioning from down to up, then we have a trend change which is positive for going long. And if the 200 MA is changing from up to down, going long is not likely to be the best position to take.
In November and then again in early December the price approached 9.0, near prior support levels and just above the 200 daily moving average. This created a horizontal channel, another formation that further helped T. J. believe CRZO had good appreciation potential. The positive divergence in the RSI and MACD indicators also implied that the price will rise further. This created another potential entry near the support level of 9.0. The Moving Average Convergence/Divergence (MACD) often can foretell a change in direction of the stock price by examining it for negative or positive divergences that might indicate the price is going to make an important move.
As a result, T.J. documented his entry levels on his watch list. His plan was to buy near the 9 - 9.5 support level and on any break of 10.87 with above average volume. For the entry near support, a stop loss could be placed below the support level of 9, at 8.75, to help minimize any loss. For the break of 10.87, his plan is to buy just above this level when volume was strong (at or above 130% projected for the day). He decided set the stop for this buy just below the the recent interim high of 10.5 selecting 10.43. Both of these stops will protect him from incurring greater losses than he was willing to risk.
Next, T.J. uses risk capital rules to set the amount of money to invest. To make this decision, T.J. considers how this stock will help him diversify his investments, the stage in the business cycle and the size of his portfolio.
In financial investment theory there are two types of risk, Unsystematic and Systematic. Unsystematic Risk is specific to a company. Should a company experience, a strike, a natural disaster, or sudden slumping sales, then the stock will be affected accordingly. This type of risk can be partially addressed by have a diverse portfolio of stocks in different industries, since events that affect one company will not likely affect another. I like to call this company risk, as it makes more sense to me than unsystematic risk.
On the other hand, some events can affect all companies at the same time. Inflation, war, and rising interest rates negatively influence the general economy, not just a specific company or industry. This type of risk is called Systematic Risk and diversification cannot eliminate this risk from your portfolio. To me a better term is market risk.
Proper diversification will help an investor to reduce the impact of company risk by spreading out your capital among different sectors. If one company or sector experiences a problem, then your loss is limited to just the fall in the stock of that one company. Hopefully, the other sectors are able to make up for that loss. Selecting sectors and stocks in those sectors that should experience positive returns offer an excellent way to take advantage of the stages in the business cycle.
However, diversification can reduce the return of your portfolio. By selecting several assets, the overall return on your portfolio will be the weighted average of the returns of those assets. For example, a portfolio made up two stocks, each with the same beginning invested capital. In one year, stock A has a total return of 30 percent, the stock B a total return of 6 percent. The portfolio return will be only 18 percent (36 divided by 2). However, if the entire portfolio were invested in stock A, the return would have been 30 percent. The reverse is also true. If the entire portfolio had been made up of Stock B then the total return would be 6%. Diversification moderates portfolio performance.
The stage of The Business Cycle helps T. J. decide whether he will invest fully, invest in stages or take a smaller position. If the economy is in Full Recession or Early Recession, he takes a small position as the market risk is high. During the Early Recovery stage, T.J. takes a full position to take advantage of the market trend. Early in the Full Recovery stage T.J. takes a full position, again to take advantage of the market trend. Late in the Full Recovery stage he will take a partial position, with the intention to add to his position if the trend of the stock continues.
The size of the portfolio is another risk capital rule to decide how much to invest in any one stock. The following is a guideline and should not be taken literally. Each situation should reflect the economic environment and your individual appetite for risk. If one is working with a small portfolio, then 5 stocks is probably sufficient to establish a worthwhile position and remain diversified. That is why the Initial Portfolio with its $10,000 starting capital will have no more than 5 stocks. However, the Premium Portfolio with its $100,000 starting capital may have 10 stocks in it when fully invested. A $1 million portfolio might have 15 stocks in it when fully invested.
Generally, it best to have no more than 15 stocks in one's portfolio. More than that and you do not have sufficient time to monitor them, assuming one spends 1 hour per week per stock in your portfolio. You also should spend the remainder of your time researching the economy, the overall market and looking for other opportunities. Often you will have fewer stocks in your portfolio, especially when the economy is weakening or in recession.
After all this, the guidelines to decide the amount to invest are straight forward. For small portfolios, consider investing up to 20% of your total portfolio capital in any one stock during good economic times (Early Recovery and Full Recovery). For a fully invested $10,000 portfolio you would own 5 stocks with an initial value of $2,000 each. When the economy is in Early Recession or Full Recession then only invest half that, as you do not want to risk your capital during economic slowdowns. It is OK to be in cash during these times.
For medium sized portfolios consider investing up to 10% of your total portfolio capital in any one stock during good economic times (Early Recovery and Full Recovery). For a fully invested $100,000 portfolio you would own 10 stocks with an initial value of $10,000 each. Keep in mind this can and does vary depending on the business cycle and companies under consideration. When the economy is in Early Recession or Full Recession then only invest half that, seeking to preserve your capital. It is OK to be in cash during these times.
For large portfolios consider investing 6-7% of your available total portfolio capital in any one stock during good economic times (Early Recovery and Full Recovery). For a fully invested $1,000,000 portfolio you would own 15 stocks with an initial value of $67,000 each, approximately. Keep in mind this can and does vary depending on the business cycle and companies under consideration. When the economy is in Early Recession or Full Recession then only invest half that, seeking to preserve your capital. It is OK to be in cash during these times.
During a bad economic times and/or a bear market, holding cash is a valid strategy. One of the characteristics of bear market is higher volatility, meaning the market moves more quickly down and then will suddenly rebound 10%, 20% or more. Volatility creates new problems for investors who are unable to follow the market minute by minute. Holding half of your portfolio in cash or cash like securities and investing the other half in ETFs that short the market offers a good way to participate in this volatility, without risking as much of your capital.
Good investors make informed decisions, recognizing when to follow the stock buy rules and when to modify them. T.J., as a Premium Member of Trading Online Markets, knew all this and decided to initially invest 5% of his portfolio, if he can get a buy near support. He would add another 5% on a break of 10.87 with volume.
Next T. J. identifies his exit strategy for this stock. There are three reasons to establish an exit strategy for each stock. First, you need to set a time limit on how long will you will hold the stock, if the price does not make its expected move. Second, if you expect to hold for approximately 1 year, then you need to consider the tax consequences of holding given your own tax situation and the tax benefits of long term capital gains. Third, since the announcement of a company's earnings can "surprise" the market, either up or down, you need to decide are you willing to hold through the next earnings release given the fundamentals of the company and the stage of the business cycle.
Ideally, your expectations for a stock's price movement takes place and you achieve your exit point. Or, in the worse case, the price hits your stop and you exit with a minimal loss. But what happens when the price does not move up enough to hit your exit price, nor does it retreat to hit the stop. Eventually you must decide to either continue holding or to exit your position. The best way is to set a time limit on how long you will hold your position.
How long you want to hold your position is dictated by the market trend, the stock's trend, how much capital you are willing to risk, and the stage in the business cycle. While this might be a lot to consider, remember you know the market trend and the stock's trend from your earlier market trend analysis and technical analysis of the stock gave you the stock's trend. Extrapolating the trend gives you a time frame for the trade. If the stock clearly fails to move with the trend then this might be a good indication it is time to move on. Also, the stage of the business cycle can help you to decide how long to hold a stock. If you are entering or in Early Recession or Full Recession then it is prudent to keep a short term holding period, such as several weeks. However, if the economy is entering or in Early Recovery and Full recovery then the length of holding period for the stock to start moving might be a longer. However, if you believe that your invested capital could be better used on another more promising opportunity, then it is prudent to exit the position to create the capital to make the new investment.
When a company releases their quarterly earnings, the market has expectations regarding the revenue, earnings and other key financial and operational data. As discussed in Earnings Season, if the market believes the company has not meet these expectations, it can quickly punish the price of the stock. Also, if the market believes the company's earnings exceed expectations, then the price of the stock can rise dramatically. This surprise affect, especially to the down side is what can cause significant problems for investors. To address this issue follow a simple strategy:
Make an assessment of the affect an earnings surprise might have on the stock. If you believe there is potential for the company to report a negative surprise, then you should either close the position or add downside protection in the form of covered call and/or protective put options.
T.J. noted that the economy was still in Full Recovery mode, oil was in a up trend and CRZO had a good support at the lower trend line and at the 200 daily moving average. As a result, he decided to hold CRZO for a year without any downside protection, as long as the previous criteria remain in place. He noted this on his watch list.
The risk-reward ratio is a simple assessment of the potential profit the trade has vs. the risk you are taking with your capital. To risk-reward equation is:
Depending on your choice of exit price, the calculation can give an investor a false sense of confidence. If you pick a high exit price, you can always make the trade look like it has a good risk-reward ratio. You must be disciplined in developing your exit price and then be conservative with your estimate. Once you have confirmed your exit price, look for trades that have at have a 2:1 to 3:1 risk-reward ratio. If the ratio is greater than 3:1 then you might want to re-examine the exit price, to be sure it is real. Any risk-reward ratio that is below 2:1, it is better to look for another stock to buy.
The final step to Stock Trading Plan is to perform a final risk assessment and document the trade strategy. Before making a trade perform a final risk assessment, reviewing the analysis one more time.
Writing down your strategy helps to finalize all the analysis. Later when you are reviewing and updating your trade it helps to know why you entered the trade in the first place. Documenting your trade strategy also provides the basis for analysis of your trade when it is complete.
Finally, we get to the stage where we may actually execute a trade of a stock on the watch list. Please read Part 5, Manage the Trade.
Thomas N. Bulkowski, a former hardware and software design engineer with Raytheon and Tandy, conducted a statistical study of stock chart patterns from 1991 to 1996. His study, Encyclopedia of Chart Patterns (Wiley Trading), statistically analyzes the performance of over 50 chart patterns identifying the best performing bullish and bearish patterns. These patterns along with changes in daily volume help indicate entry, target and exit rules for trading stocks. Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications (New York Institute of Finance) by John Murphy and Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications (New York Institute of Finance) by Steven B. Achelis are good sources on technical analysis.