Rule 1 - Downside risk must always be controlled and low.
When the conservative trader buys a stock, 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 and 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).
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 you must 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 raise the stop. Maybe you can reduce it from a 10% stop to 3% or 5% stop 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 equal number of shares.
For example if you bought 10 shares at $10 (and you had your initial 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 position 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 with this new company. 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 eventually 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 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, don’t 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.
One more point to make about how to handle a rising stock. Of course if the 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. Don’t 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 3 - Buy on Volume
Here 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 before end of chart 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 tale 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 rule 2. Rule 3 is to 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 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 3 - Buy on Volume (cont)
I wish to continue the discussion on price and volume since this is very important to all investing. The focus this time will be support and resistance. It was mentioned in the previously 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 each time 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 rises again 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 4 – Buy when Quiet
We discussed how to identify a stock for purchase using price and volume. 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 for 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 5 – Check the Fundamentals - BWLD
When purchasing a stock 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 financials 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 appreciation.
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, it’s 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. 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.
