Gross Domestic Product

Great news on GDP today, we have now had four quarters of improving GDP. Today’s number showed GDP up 5.7% and is the second positive number. The critics say it is stocking up inventory only causing it, however when companies see an upturn coming they need to fill their inventory. This means since the last two quarters have been positive now it clearly puts the recession behind us which some say was the worst recession since the great depression.


The stock market as measured by the Dow took the news with a jump of +110 points at its high only to later fall back and end down -53 points. This is why it’s important to follow the trend and wait for a follow through day. Some of the biggest jumps can occur in a down market and people can get suckered back in. Wait for the indexes to come off their bottom then confirm 4+ days later with a follow through day. If you don’t do this you end up buying stock on every temporary jump back up.

One final thought, GDP is a measure of top line growth and does not necessarily reflect a companies profits, it is more a measure of production increases. To people that say the market should be up on this news and not down all I can is we have just had a 60%+ increase (as measured on the DOW) since March 09 and now we have a 6% correction. This should be expected as nervous people with big profits start taking those profits. Let’s wait and see if the market can stabilize and form a new base, only time will tell.

Be Wary of the Wise

I can tell you now, I have no idea whether the stock market will up (or down) tomorrow or next week and the same reasoning applies to individual stocks. The best judge is by watching the price and volume action for hints which will put the odds in your favor. Of course even that can be wrong since a stock can change direction at any time, even after your research suggests the opposite. People look to the ‘experts’ for direction and picks but that is a misguided outlook. When you watch financial programs for every stock recommendation up there will be an equal recommendation that the same stock will go down. For every analyst that says the Dow will climb, another analyst will say it will fall. Some hedge their bets so they are right in both directions by saying they are short term negative but long term positive. Some will say buy a little now and buy more on weakness, again they are right regardless of direction, lets hope it doesn’t continue down after buying more.


Opinions are worthless which of course includes mine. When I mention a stock I am only selecting stocks on an ‘odds favor’ basis. I use a statistical approach with very careful money management because I know that however good a pick may be when the indexes fall then the very best of stocks will also fall. It is a fact that 90% of all stocks will fall in a bad market. For this reason you must always use money management techniques. In fact I would say money management is far more important than stocks picking. With good money management skills you can make money even if you buy bad stocks, the reason being even bad stocks can go up in a good market. Since we are now in a down trend which could end who knows when, maybe now would be a good time to review the rules I outlined as a refresher in early January.

Many readers are looking for me to mention stocks that they can add to a watch list for possible later purchase. I cannot do that since I know 90% of all stocks will fall in a down market. Better to look for stocks making new highs soon after a market down turn ends, because the stocks making new highs first are the truly powerful stocks. The stocks making new highs early after a market fall clearly didn’t fall as much to be making new highs so early. They do that for a reason and are the ones to buy if they break out on volume.

Human Nature

It is human nature to want to take profits yet when we own losing stocks we tend to stay with them sometimes for years if not forever. Let me walk you through a scenario you may see yourself as having done many times. I will explain it in three parts.


1. You find this great company (company A) that has a fantastic future, or so you believe. You buy the stock and it hesitates and maybe drops down a little. You stay with the company after all it has a great future. It recovers and now your back to break even, feeling great you know it will go up. The stock goes up 10% you knew all along this would be a winner. The stock rises more it’s now up 15%, gosh you’re a genius, you tell all your friends. You now feel a little nervous and want to lock in that profit. It now rises again to an 18% or 20% gain then hesitates a little perhaps falls back to a 15% gain. You sell out worried it will continue to fall and tell all your friends what a genius you are with this profit. You found a winner and made some nice cheese from it. Emboldened you look for another company.

2. You find another great company (company B) that also has a great future or so you believe. The company goes up a little, falls back a little. Couple of weeks later it is still around your purchase price. After a month you get bored and sell the stock. Oh well no big deal, you didn’t lose or gain so let’s find another.

3. Yet again you identify a third great company (company C) and buy the stock. It does nothing for a few days then falls 5%. Oh well no big deal it will recover it’s a great company with great prospects. Next week it’s down a total of 10% but you know it will recover. The next week the Dow has a few bad days pulling all stocks down, your stock is now down 20%. The stock recovers a little over the next few days so now it’s down only 10%, you knew it was a good company. Oh dear suddenly it’s down 20% again and you say I have had enough of this, as soon as it get back to break even I am going to sell. Suddenly the stock is down 30% and you think to yourself no way am I taking a 30% loss I am going to wait for it to recover then consider selling. Oh my goodness just before vacation you notice it’s down 40%. I don’t care any more so I leave for a good vacation. Well the story goes on and the stock keeps falling. Your ego refuses to take a loss then one day perhaps a year down the road you still own it and its down 80%. Most people I know at this point will either hold stock C forever or sell it to take a “tax loss”. Your pride now justifies the sale after all it’s a tax write off.

Now let’s look at this statistically we buy all three stocks with returns of 20%, 0% and -80%. Of course I don’t know what will happen to those three stocks but we do know that statistically those three things could happen (up, down and sideways). In practice because of human nature we cut our gains short yet we let our losses ride. I can assure you that is what most people will do.

DO NOT do that you must work against your human nature. Cut your losses quickly at 10% or even better and let your winners continue to win. You are in a much better position to take the 10% losses and collect the 100% gains. If you let human nature control you then you are destined to large losses but only small gains since you always sell your winners. I have already given you the tools on how to know when to sell your winners, remember the high volume falls as an indicator and/or the crossing of the 50 day moving average. Remember winners tend to continue to go up and losers tend to continue to go down.

Follow Through Days

Readers should now be sitting on their hands, buying no stocks and maybe tightening those stops on stocks that are performing well that they may still own. As an investor you will strive to move the sell stop up to zero as the stock moves up. Do not initiate new company positions.


The reader is now watching the market as it continues in its down trend. Last two days were up or flat on very low volume and this is usually considered a suckers rally which will try to entice you to buy more stock. You can never know where the bottom of this new down trend is otherwise we would all be rich. All you can do is select an “odds favor” point to start buying which may or may not work. The “Follow Through Day” has been widely publicized by the famous investor William O’Neil who started the Investors Business Daily newspaper. O’Neil suggests and indeed has validated that the best time to start buying stock again after a downtrend is when we have a follow through day. A follow through day does not guarantee we are starting a new uptrend however no new uptrend ever starts without a follow through day. The follow through day puts odds in your favor that a new uptrend of unknown duration and unknown gain MAY have started but this is NOT a guarantee, follow through days can and do fail.

A follow through day occurs within 4-11 days off a stock market downtrend bottom. Since the last bottom was 2 days ago we cannot expect a valid follow through day until at least the fourth day from the bottom. If a new low occurs (lower than two days ago) then the count is reset to zero and we count 4 days from that new low. The follow through occurs when the market goes up on high volume of approx 1.5% gain or better. In other words we want to see the market move up from its low then stabilize or pull back a little then move up again on high relative volume, this is the follow through day.

We need to look for follow through days because the biggest up days occur in down markets and can suck you in when you shouldn’t buy. As markets become over sold after some big falls they reverse to the upside only to fail later. The reader should not buy on a big rise in a down trend unless we have a follow through day first. The reason for this is to reduce the chance that we have a false reading that the down trend has ended. As I said before there is no guarantee and the down trend can still continue….its just odds favor.

Caution

Caution has to be the operative word. All major indexes have been falling on very high volume. These are known as distribution days because the bulk of the trading has been on the sell side. The Dow has lost over 500 points in three days on heavy volume before today and broken below the 50 day moving average. Such steep downturns will cause bounces back up to occur as the indexes reach an over sold position, do not be caught since this is not a buying opportunity. The investor has to pay careful attention to the nature of that bounce back up. In a down trending market any bounces occur on lower volume as happened today. The Dow bounced up 23 points today on lower volume after having been higher earlier in the day. It is not unusual to have a few low volume up days before another heavy volume down day occurs and the selling resumes. Until we see high volume up days we should stay on the side lines. Manage the stocks you currently own and stay with them if they are behaving well, tighten stops as appropriate. Do not add new positions in this unfavorable period since you run the risk of being stopped out very quickly. So far the down turn is not serious and we are hugging close to that 50 day moving average, lets see what the future brings.

FLAGS

Flags are a pattern on a stock chart that describe a bullish behavior and should be bought in the “quiet” area. When a stock rises big in one day or maybe just a few days the graph looks like one line going up, the volume must also be very high. Then the inevitable consolidation (or maybe a small sell off) will occur as people consider the stock has moved too high too fast. The stock will now do nothing and move sideways for a while, it may even fall a little. This sudden rise on high volume can be visualized as a flag pole and the sideways to slightly down action on low volume the actual flag. This quiet period on low volume is the buy area before the next big rise (if it occurs).


Consider it from a psychological point of view. The buyers drive the stock up since they know something good about this stock. Maybe it’s an earnings report and it is public knowledge or maybe it is just insiders which have information that is not yet public. Then as the sellers come in the stock will move sideways to down for a while until all sellers are exhausted. As the buying and selling dry up to negligible levels the price action gets extremely quiet. If there is demand for the stock the buyers will get impatient as they see the stock will not fall any more. Realizing they can’t buy stock any cheaper they then pile in again and drive the stock up forming a new pole of another flag as it breaks out to the upside again. The graph below courtesy of www.bigcharts.com indicate this if you examine the circles in the price and volume charts.

Of course if there are no more buyers for this stock the quiet area is viewed by the sellers as being a point where the stock will not go any higher. The sellers want as high a price as possible but give up on the stock going any higher. At this point they may start selling on volume as all the last flag breaks down. At the end of this chart you can see the heavy selling coming in. At this point you should be lightening up on your holding of this company, not buying more.

Regarding current action in the stock market the investor should be cautious at this point. Do not buy any new positions while the Dow index is trading under its 50 day moving average (see yesterday’s blog). The trader can still add high volume breakout stocks to his or her watch list but be sure to remove stocks from your watch list that are clearly breaking down on high volume, these are no longer potential buys. Remember in a down market 90% of stocks will get hit, even the good ones. Remember to move the stops up on any positions you currently own. In any case the investor should only have one or two positions that are negative since previous blogs have indicated you wait for a new investment to break even before you buy any other new companies. This is how you limit your downside losses. It’s always nice to have lots of profitable positions and only one or two potential losers. Those losers will have a maximum of 10% loss and maybe less if you have been moving the stop up gradually as the stock rises. Also its only 10% of a very small position since companies in which you have been adding additional positions are already in profit and your stop is set to break even at the very least.

50 day moving average PNRA, FFIV, EL

Today we should discuss moving averages. You have to remember that even though the stock market has been in an uptrend since March we have had many instances of short sharp down turns which tempt people to sell their holdings. It is a good idea to look at the major indexes such as the Dow, Nasdaq and S&P to determine the overall health of the market and decide whether to make a purchase. Once you have a purchase ignore the major indexes and just follow the individual stocks you own managing each position in isolation. If the Dow is falling but your stock is holding steady or rising then you have no reason to sell.


A very good indicator as to the health of the market or an individual stock is the 50 day moving average. This is a way of smoothing out all bumps in the price so you can focus on what the trend really is. The 50 day moving is calculated by taking the closing price of a stock or index for the last 50 days and adding them together then divide the result by 50. Each day you add the latest number and drop off the oldest number and recalculate. Luckily for us most stock chart services offer the 50 day average as a line you can plot on the stock or index you wish to study. Take a look at the Dow Jones 1 year graph below and its 50 day moving average which has been plotted, courtesy of http://www.bigcharts.com/.

Notice how since March when price crossed over the index the 50 day moving average has made a steady climb upwards. Also notice how the Dow index mostly trades above that smooth line. As long as that holds you generally should consider the upward trend has not changed. Notice how many times the Dow index has approached the 50 day moving average line only to jump up again and often on increased volume. In fact if you are considering a purchase the best time to buy is as the Dow approaches that line and jumps up from it. This usually indicates that support has been found at this level. Some time back we spoke about support and resistance levels using channels. The 50 day moving average also often acts as a support line as the index or stock rises. Each time it gets close to the 50 day average it bounces up off it. In a downtrend the index or stock will trace below the 50 day moving average line and stay below it until the trend changes (this can be seen at the very start of the chart). In a down trend the average acts as a resistance line and every time the index or stock approaches that line it usually reacts back down again as the downtrend continues. The indication of a trend changes is when the stock or index breaks through that moving average line preferably on increased volume. Of course this does not work 100% of the time but is a great indication that works most of the time. Occasionally a stock in an uptrend might briefly fall below the moving average on low volume only to follow that line before it moves back up again.

Remember investing is an art not a science, nothing is guaranteed. It is all about “odds favor” and that’s why we have to build positions gradually rather than make large outright purchases.

Look at the same chart below over the last 6 months.

Price has approached the moving average again as we had on many previous occasions (see in circles). We are at a very strategic point in the recent uptrend. We are currently testing the moving average on increased volume. This is not a good sign and the buyer of new positions should hold off and watch the action over the next few days. If it bounces up then the uptrend is reconfirmed at this critical juncture. If the index collapses through the 50 day average on volume then we can consider a trend change of unknown size and duration. When we are in a down trend I will talk later about what to watch for to identify a new uptrend.

Now let’s identify some stocks breaking out to be added to our watch list for possible future purchase (assuming we don’t enter a down trend in the averages). The stocks below have all shown breakouts on good volume even in spite of the bad market today.

PNRA - $73.41

FFIV - $54.61

EL - $53.63

P/E Ratios - LZ

Many people purchase stocks that have low P/E ratios. The feeling is that the stock is under priced. A P/E ratio is price/earnings ratio and is calculated on a per share basis. For example a stock at $20 which has $1 in earnings would have a P/E ratio of 20/1 or 20. Depending on the industry class ratios under 15 are often considered inexpensive. My belief is that P/E ratios can be very misleading and my research suggests that if you try to buy low P/E ratio stocks then you miss most of the winners.


A P/E ratio can be low because of low stock price or high earnings. If the price is low then one should assume it is low for a reason since the stock market is forward looking. A stock may have a P/E ratio of 10 today but if the next earnings come out at only half of the last earnings that immediately adjusts the ratio up to 20 from 10. Suddenly the stock looks expensive and if the earnings get worse the P/E ratio would be much higher.

A stock with future earnings potential usually gets bid up in price even before the great earnings come through making the P/E ratio appear very high. A stock might appear expensive with a P/E ratio of 50 until the day it announces great earnings, then suddenly the P/E ratio drops to some low level because of the high denominator (high earnings). Of course the price then starts climbing in recognition of the great earnings and up goes the P/E ratio again.

My suggestion is ignore P/E ratios.



LZ - $82.94

This stock is up on double average volume today even with the market down and is breaking into new highs. Earnings history show gains of 169% last qtr and 71% the qtr before and should be added to your watch list. The stock is currently extended and ripe for a sell off but should be reviewed if a pull back occurs on low volume. Of course a pull back on high volume means this stock should be removed from your watch list.

 
 

TSYS

TSYS - $10.02


This stock has just broken out on almost triple volume and should be added to your watch list for possible future purchase. This company has an 83% jump in earnings over same qtr one year ago. If you conclude this is a buy then wait for the pull back when the stock goes quiet on low volume (if any stock pulls back on high volume then it should be removed from your watch list). This stock is currently extended and could easily retrace back to the pivot point. Remember to use the sell stop after any purchase since any stock can fall if the general market decides to fall.

Rule 5 – Check the Fundamentals - BWLD

When purchasing a stock I always think WHEN, WHAT and HOW. We have covered WHEN to buy since it is when we see a stock break out of a high level channel then go quiet (low volume very little movement). We have the HOW to buy, basically we have a pilot purchase of a small amount of stock that wont keep us awake at night. With a 10% stop sell we would lose very little if the stock falls. You don’t need all your picks to win. Even if you pick just a few winners and all other stocks fall, you can still be ahead of the game as you build bigger positions on your winners. Now we need to cover the WHAT to buy.


We don’t just buy the breakout we need to ensure they are making lots of money. Check the stock fundamentals, at the very least you want to see qtr over qtr earnings gains of 30% or more. The bigger that number the better, try to find stocks that are having earnings gains of 100% or more over the same qtr a year earlier. If you can’t find the big earnings gains then at least try and keep it to 30% or more. If a company is not making money then there is no reason for long term stock price increases.

Now the reader will point out stocks that have doubled with no earnings and point out stocks that have gone down with fantastic earnings (doesn’t this drive you crazy)? This is because the market is a forward looking mechanism, price is really determined not by what is being reported today but what is likely to happen in the future. You may ask well how can we possibly know that and I say that’s why you look at volume. Massive up volume suggests that maybe earnings are going to improve, maybe somebody knows something. So now you say we can forget about earnings then, well the answer is you cannot. As an investor you have to put as many factors in your favor as possible. You want the great volume and the great earnings. Remember a company that is doing well with consistent great earnings is likely to continue that way at least for a while, just look at Apple.

Look at the history of great companies like Wal-Mart, Intel, Cisco, and Oracle to name just a few. In the days when they were climbing fast and having stock splits every year they also had great growth in their earnings. Those companies today struggle to get the stellar earnings growth year after year that they once did even though they are still great companies with great products. When a company is making lots of money its tough to keep increasing those earnings by 50% year after year. Those companies go from being growth stocks to eventually becoming large cap income stocks. If you were to plot earnings versus stock price over a 10 or 15 year period using each quarterly earnings you would see a very close correlation between earnings growth and stock price. Notice I say earnings “growth” because having the same earnings as last year is just flat so you can expect the stock price to also be flat. A company can report a great profit but it doesn’t help if it’s not beating the same qtr a year ago by a large amount.



Before I leave this topic I want to point out that a company can report great earnings yet the stock plummets and visa versa. Two things could be at work with this situation. Maybe the stock has just climbed much too fast and has got way ahead of itself or maybe something somewhere is suggesting tough times lay ahead. Remember it is all about the future not what is happening now. A stock price is set by what will happen, not what is happening (or has happened since an earnings report is about the past anyway). Finally a stock price is also affected by what the general market is doing. When the major indexes are going down you can be sure that 90% of stocks will also follow it down but maybe the great companies will fall less. You can usually expect 90% or more of companies to follow the general market. This suggests you do not want to be buying stocks in a falling market but more about that another day. One word of warning you should not buy if the earnings report is imminent. That is gambling, who knows what the results might be. Better to wait so you can build up a profit as a buffer before the next earnings report.

The following stocks are NOT recommendations to buy. Add them to your watch list and do your research first or consult your advisor. I you conclude they are a buy then wait for the pull back when the stock goes quiet.

BWLD - $46.15

This stock has just broke out on at least triple the volume. Latest quarter shows 46% qtr over qtr earnings growth with great growth in previous quarters. This would look interesting if a pull back occurs on low volume. Earnings due Feb 11th.

Rule 4 - Buy when Quiet

Yesterday we discussed how to identify a stock for purchase using price and volume. Today we need to choose the exact buy point of that stock. When you see a stock breakout on high volume from a recent consolidation you have identified a stock of interest. Even if there is no news somebody knows something or we wouldn’t see significant buying volume and a rising stock price. The temptation is to buy it immediately but unfortunately that’s the wrong thing to do. Every big stock price jump is susceptible to profit taking after a good rise. In fact it is very common fall a stock to fall back to its “pivot point” after an initial high volume break out. The pivot point is the point at which the break out started, it would be the top of the recent resistance area or consolidation. Don’t buy a breakout on volume only to see it fall back and you get stopped out with a 10% loss. Every rise will be greeted by profit taking at some point because of nervous stock holders wanting to bag that profit. The time to buy is after the stock has broken out on volume and then you see the pull back on very low volume. If the stock is truly a good buy there should be very little selling. You would see the stock grudgingly fall back then go horizontal for a while. That’s a “quiet” stock and that’s the time to buy when all sellers are exhausted. We don’t want a stock that breaks out on volume to the upside then falls back down on high volume. That suggest you have serious selling and the stock may not be a good buy.


Take a look at the graph below courtesy of www.bigcharts.com for stock symbol TSTC.

This stock has climbed relentlessly on high volume regularly only to fall back each time on low volume. Note the high volume spikes as it jumps up out of each consolidation (quiet area) at mid October, mid November, begin December, early to mid December, late December and again early Jan. Before each of these jumps we have a “quiet” period where you can add stock to your initial holding. The stock has gone quiet and is consolidating on very low volume. All the sellers have been exhausted and “maybe” the buyers are waiting to jump in again thinking they can’t get it any cheaper. One interesting point here is the last couple of trading days has shown some high volume spikes on falling price. This is not yet a sign of trouble but should be watched closely. The $19 level which is the base of the last trough where the last selling ended will act as support. If it falls below that support especially if it falls on volume then that is the time to start taking some profits. You would sell some and sell even more if it continues to fall on volume. If upside movement returns on volume then you can start adding again.

Rule 3 - Buy on Volume (cont)

I wish to continue the discussion on price and volume today since this is very important to all investing. The focus this time will be support and resistance. It was mentioned in the previous blog that you should only buy high volume breakouts. A breakout is the price going above the previous high. Often you will see stocks attempt to break out to new highs but fail and fall back. Often a high level channel will form where the price just cannot break out. If the price does eventually break out to a new high above the old price it has to be suspect unless it breaks out on volume. Often a breakout will fail to only fall back into the channel and continue that high level channel. Look at the chart below of stock symbol COO courtesy of http://www.bigcharts.com/ illustrated again is price and volume but over 6 months.

The reader can note that mid November shows a high level channel where the price is hovering around $32 for about two weeks. Notice how after one week it tried to break out to the up side but failed. Eventually it broke out on at least double the volume and rose to $34 before a new consolidation set in again for about 2 weeks. Another break out occurred to $38 in early December. To date a couple of attempts to further break out have failed. If you were considering buying this stock (or adding more if you own it), then wait to see the price moves above $39 on high volume (without the volume it could easily fall back into the channel). Of course when you add to the position here you will then calculate your new break even point and raise your stop accordingly. The reader must realize that stock investing is an art and not a science, even after all this preparation a stock can still fail at any time. The point has to be that it’s an “odds favor” situation that may or may not work to your advantage. You must approach the market from a statistical point of view. You will have many losers with a loss of $10 as you get stopped out on the initial purchase but hopefully as you find your winners and add to them they will far outweigh the small losses. Remember you don’t want a whole string of stocks that have not yet met their break even point, just buy one or two and when they get to break even buy other stocks.

Let’s discuss the psychology of the price channel at a high. Imagine investors bought the stock close to $39 and it falls back. Many people will get nervous because they own a large block at $39. Often those investors will sell as soon as it gets back to their buying price. They will sell it and be relieved that they got out without losing money. This is a resistance level and the stock has to overcome those sellers before it can move higher. Once the stock gets above $39 every single stock holder is in profit and feeling happy about their investment. Typically as the stock breaks out you will see a rapid rise up to some new level as we have seen on this stock the previous weeks. It will then consolidate at some point as it appears expensive and at some point the nervous sellers will return. As long as the selling is on low volume you should sit tight. Very soon the stock will find its new level and start moving sideways again to form a new high level channel, since anyone that wanted to sell will have sold and new buyers won’t appear until it starts moving up again. This is the dull low volume price action that should not be bought or sold. The next high volume move will tell you the new direction of the stock. Nervous sellers will be indicated by a low volume sell but if the insiders start selling the tell tale sign will be a high volume fall telling you the game is over and you should sell some if not all your holding.

On a final note when a stock falls and settles down in a low level channel that is called support. It means every time the sellers take it down to that level then buyers return because it looks so cheap, that is called the support level.

To summarize stocks move up and consolidate into resistance channels or stocks move down and consolidate into support channels. Let the stock show its hand by moving out of that channel on high volume up or down before you make your next buy or sell decision.

Rule 3 - Buy on Volume

Today I wish to talk about price and volume. Note the graph courtesy of http://www.bigcharts.com/ of stock symbol PKG. Here we have a 3 month chart with volume bars along the bottom. You can see up volume in black when stock price is increasing and down volume in red when stock price is decreasing. Price and volume are the two most important parameters when studying a stock chart for a potential purchase. Volume is a measure of how much stock is being traded. The actual number doesn't really matter. The important thing is the relative measurement of volume compared to the day before. This stock has been under accumulation since start of December. Notice how price goes up on higher volume and falls back on lower volume. You can very clearly see the stock move up at the start of December, mid December and again in early January. Any pull backs are on much lower volume as you can see in late December. This tells us that someone is building a position in PKG and odds favor it will continue to rise (although this trend could change at any time). Just 3 days ago we had at least double average volume  as the price surged up. Now as it falls back again the volume is starting to decrease. Put yourself in the position of an insider that wants to accumulate a large position in the company because of some favorable event that may occur later. The trader wants to hold a large position but knows that if a large order is placed that will drive the stock up to prices that are no longer a bargain. The trader will buy a little stock and drive the price and volume up as he continues buying. The trader wants to buy more but the price is getting too high so he takes a back seat for a while. Joe public comes in seeing the big rise and starts selling to take their profit. Eventually the sellers will have exhausted and the stock goes quiet (small price changes) on low volume. The insider who wants to own lots of stock knows the price is unlikely to fall any more (sellers are exhausted) so starts his volume buying again. The tell take sign is that suddenly we see heavy buying again and the volume bar goes up as well as the price. This process continues until the insider has his allocation of stock or until he considers the stock is no longer at a price worth buying.

At some point we will see the inverse called distribution. The insider that accumulated this stock has decided to sell for some reason. He knows he can't dump it all because that will depress the price he gets for his stock. Instead you see a down bar on high volume like mid October then the insider will stop selling and hope the price recovers on low volume as Joe public starts buying it. When the insider sees the rise end in comes the heavy volume again as he considers selling much more stock until he is sold out.

The reason we look at price and volume is to determine whether a stock is under accumulation or distribution. Of course this can change at any time and that's why we protect our investments using rule 1  and 2. Rule 3 is buy on up volume, we wish to buy a stock that appears it is being accumulated. We like to see a quiet stock with little volume suddenly start moving to the upside on very heavy relative volume. This tells us someone has a reason to buy stock and we want to be following that insider. Most of the time stocks will just drift up and down along with the Dow Jones and meander with no direction. Those are not the stock to buy. Most of the time most stocks will meander but there are times when they are under accumulation or distribution and that's the time to take notice.

In summary only buy stocks that are under accumulation which can be noticed from stocks moving up on high volume and falling back on low volume. Every stock that falls back on low volume is another opportunity for you to buy more as the selling ends.

Rule 2 - Achieve break even stop as soon as possible.

Once you have made your first purchase you have 10% of the investment at risk (or 0.1% of the total portfolio assuming you have a $10000 portfolio and $100 invested as a seed). Your second purchase is probably your most important purchase as you start adding to this position to make it a larger low risk investment.

After your first purchase you are risking $10 (10% of $100 invested). As the stock moves up raise the stop to reduce the 10% to 0% at risk. DO NOT raise this stop too early. Most stocks will react a little on their climb up. It is better to wait for a reaction then as it moves up on volume (will talk more about price and volume in another blog) raise the stop. Maybe you can reduce it from a 10% stop to  3 or 5% reducing that $10 risk. When the stock has climbed above a recent consolidation on volume that is the time to make your second purchase of an an equal number of shares.

For example if you bought 10 shares at $10 (and you had your intial sell stop at $9) and the stock is rising on volume and lets say it is at $11, then it may be time to make your second purchase. The importance of the second purchase is to move your loss profile from a $10 loss to a $0 loss if stopped out. If you select an approximate mid point between the old purchase and new purchase price ($10 and $11) then place a sell stop at $10.50 for the whole position. Actually it would be slightly over $10.50 since your first purchase is a $100 investment and your second purchase is a $110 investment (I use Excel to store my positions and calculate my break even point).You should now be a happy investor since you have a position where if stopped out you lose no  money (excluding commissions).

You now have an investment of $210 and if stopped out at  the stop price will walk away with no loss. At this point you can add more stock to  the original poistion as it climbs. After the second purchase of your first stock when risk is reduced to zero you can consider buying a new stock and doing the same again on this new company. We will talk about this later but as stocks keep breaking out to the upside on high volume you keep buying another 10 shares in the above example. Over time the current stock price will move further and further away from the stops you recalculate each time. Every time you add to the position you recalculate your break even stop point and apply it. If this stock continues on up you will eventaully have large positions with very little chance of being stopped out.

You can imagine a time when you have made perhaps 20 purchases and have a lot of money invested. You do not wait for the stock to retreat to your sell stop level since you would be out at zero gain. You watch the rising stock and sell a portion (maybe 25% of your holding) if the trend changes and it starts falling. If it continues to fall then sell another 25% and another until your out of the position completely as it falls. Since you are selling stock for more than the price you paid then you have profit and when you put these numbers into Excel it has the effect of lowering the sell stop value needed to break even giving you an even bigger safety margin.

If the fall was temporary and the stock resumes its rise then start adding 10 shares at a time again. A word of caution dont get too greedy. If you start buying too many shares too soon as the stock climbs then the break even point gets much closer to the current stock price and you run the risk of being stopped out at break even on just a small correction. Keep adding just the 10 shares until you have a wide margin of safety between the current price and the break even stop price. If the gap becomes significant you can then consider buying 15 or 20 shares at a time and later on even more. A later blog will talk at length about price and volume also what stocks to buy and when to sell.

One more point to make this blog talks about how to handle a rising stock. Of course if your initial investment was a bad investment and the stock goes down you lose $10. This is an acceptable risk since your winning stocks will show much greater gains than that loss of $10. Dont go out and buy five different stocks with a $10 stop all at once because if the market turns down you have $50 at risk. Better to break even on an investment then start another.

Rule 1 - Downside risk must always be controlled and low.

When  the conservative trader buys a stock then always use a sell stop of 10% or less. Also an initial trade always has to be a VERY SMALL amount of money. It has to be an amount that will not cause you to lose sleep at night. A small amount is different for everyone, if you have $10000 total to invest over time lets assume $100 invested will not keep you awake at night. If you invest $100 with a maximum of 10% sell stop that is $10 at risk or 0.1%. This seems nothing but has to be considered a seed. The seed will grow over time into big oak trees. You will add to this investment if the stock goes up. You will let the planted seed whither and die if the stock falls which will cost you $10 max (10% of the $100 invested).