The Ultimate Treasure Hunt!
Friday, October 19, 2007 | Teeka TiwariRating:
The big question right now, of course, is whether the market will break through 14,200 and power on, or fail here and take a trip to 13,200 first. You are going to want to have a game plan for either eventuality.
The first question you want to ask yourself is whether you believe that the market is in an uptrend, or is preparing for a new downtrend? This is the most critical question you can ask yourself because all of your investment strategies will flow from which side of the investment fence you sit on.
My opinion may not be your opinion, but I believe that we are in an ongoing long-term uptrend, and so my investment decisions and this article are guided from this viewpoint. If you are a bear, you can still use this article to help you make money - just reverse the process.
With the market waffling around the last couple of weeks, it’s easy to just tune out. Don’t do that. Weak periods in the stock market are an excellent opportunity to do some serious treasure hunting! Now is the time to start identifying those stocks that are bucking the current market weakness.
I have found that stocks that do well during periods of market weakness do exceptionally well during periods of market strength. So one of the things I look for at a time like this is those stocks that are bucking the trend. Stocks that are rising, but are doing so independent of any news event. These are the stocks that the informed money crowd are quietly scooping up for themselves.
A good habit to get into is to always have a list of stocks that you will buy on weakness. With the “whippiness” of today’s market, the old momentum approach of buying on new highs with a very narrow stop loss doesn’t work anymore. Even great stocks will re-enter their base after breaking out, even if it’s only fleetingly. This is a phenomenon that is occurring so much now that it’s rendered this investment approach virtually moot, in my opinion.
The Solution
I’ve found that the lowest risk time to actually buy a stock is when it’s at the bottom of its established trading range. Now this is where Point and Figure charts shine. Unlike a line chart, Point and Figure charts explicitly show you the trading range of a stock. This type of an approach would have been anathema to one of my trading heroes, Jesse Livermore.
Jesse Livermore made a fortune as a momentum investor. He had a unique knack of calling pivot points in the market and then aggressively pyramiding his profits to compound his gains. His approach was to buy stocks breaking out to new highs on big volume and to always add to the position at higher prices. Jesse Livermore was a master at using leverage to his complete advantage.
What I do is a little different. I look for stocks that are in either a solid long-term uptrend or in a base-building period that I feel are about to exit their bases to the upside. Where I differ from Jesse is that I rarely buy breakouts anymore. As more and more people have come into the market, there are more and more false breakouts, and the chance of getting whipsawed is, in my opinion, just too great.
So what I attempt to do is buy in at the low end of the new trading range of a stock. So if a stock has already broken out of its base, I will invariably wait for the reaction selling and buy it on the pullback.
In the case of a stock that is basing that I think is on the verge of breaking out, I will wait to buy it at the bottom of its trading range. Most stocks that are exhibiting a basing pattern have a very solid price pattern that they fluctuate within.
The main advantage of this approach is that, if I’m right, I get bigger and faster profits. The other advantage I get is that if I’m buying at the low end of the trading range, I have a very well-defined exit point. If the stock breaks below the established trading range then without mitigating circumstances, I get out of the stock.
The safest time to buy with the most leverage and largest position is when a stock is at the low end of its trading range, not the top.
If you are a fast money trader type with a huge appetite for risk, then this is an excellent strategy. For example, let’s say a stock is in the $42 - $48 range. On a move to $42, a hyper-aggressive trader will buy calls and sell puts ... lots of them. But if the stock ticks $41, a clear breach of the $42 low end of the range, he will immediately close out all of his positions.
Our imaginary trader has a hard and fast stop point allowing him to be much more aggressive than if he tried to buy it at $48 in hopes of the breakout. You see, if he buys at $48, the stock can decline all the way to $42 and still not provide a clear sell signal. That’s $6 of risk without knowing if you’re right or wrong on the trade!! That’s insane, and no pro using highly leveraged positions would ever do that.
If our trader buys at $48, and even if he uses a $1 stop loss, let me ask you which trade has the higher probability of being profitable: buying the stock at $48 with a $1 stop in the hope that it breaks out, or buying it at $42 with a $1 stop in the hope that it breaks out?
It’s obvious isn’t it? Because even if the stock fails to break out, by buying at $42, you get to make money even when you're “wrong” as it runs up to its old trading high of $48!
The key to this approach is to have a strong trading knowledge of the stock in question. It should have a history of holding its lower end prices unfailingly. This way, you will be less prone to being whipsawed. Don’t kid yourself, whipsaws will still occur, but they will happen a lot less frequently by using this approach.
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Teeka Tiwari
Chief Investment Officer
ETF Master Trader
