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"The market is a treacherous and fascinating game. I am a player and this is the quiet place i go to pen my thoughts and emotions."

Saturday, June 03, 2006

Perspective/Chart: When to buy? When to sell?

PerspectiveChartToday I would like to introduce my system of entry and exit. Like many other methods, it involves the elements of selection, timing and cutloss.
However, there is an additional element of testing, which I feel not many people in the market practise enough.

Selection:
Some traders may not filter their stocks based on any criteria and prefer to trade solely on the basis of Technical Analysis. I am fickle and sometimes I do that as well but most of the time I try to trade stocks that have already passed my criteria of Price/NAV, PE, earnings growth, Price/cash, Debt/Equity, industry outlook and Div yield. When I trade, I am aware that some trades are more risky than others if I do not filter them via a selection criteria first.

Timing:
Mechanically, I usually rely on the MAs, Stochastics and Bollingers. These represent the principles of "Support/Resistance", "Overpricing" and "Overdeviation". Additionally, I also look out for MFI divergences and candlestick patterns to reinforce this system. And finally, I put these criterion into context by observing the prevailing trend(ie. higher highs and higher lows, or lower highs and lower lows).

In an UPTREND,
  • The MAs act as a source of support. Stochastic indicates if the stock has been overbought. Bollinger indicates if the price has overdeviated from the mean.
  • Bullish/Bearish candlesticks provide confirmation that the short term trend has reversed.
  • So a buy signal is generated when the price hits the MA of your choice AND a Bullish candlestick pattern has formed. A sell signal is generated when the price recovers from the upper bollinger, the stock has been overbought AND a bearish candlestick pattern has formed.
In a DOWNTREND,
  • The MAs now act as a source of resistance. Stochastic indicates if the stock has been oversold. Bollinger indicates if the price has overdeviated from the mean.
  • Bullish/Bearish candlesticks provide confirmation that the short term trend has reversed.
  • So a buy signal is generated when the price recovers from the lower bollinger, the stock
    has been oversold AND a bullish candlestick pattern has formed. A sell signal is
    generated when the price hits the MA of your
    choice AND a bearish candlestick pattern has formed.
Most of the time, not all the indicators will be triggered at the same time so it is up to the trader to make a judgement whether to take a position or not.

Cutloss:
The cutloss is an exception handler. Your cutloss receptors should be up all the time once you have taken your position. Suppose you took a postion but the immediate result was counter to what you had expected, what should you do? You should allow a margin of error to occur before you hightail out of your position. You followed your system to the letter and yet the market disagreed with your opinion. Take that small loss and accept the fact that your system is not perfect before you inccur the mother of all losses!
The cutloss can be an absolute % loss you are willing to take or it can be based on time or based on indicators or candlesticks. Whatever your criteria of cutloss, the main reason should be a non-response to your timed position. You entered the position expecting the price to head somewhere. If it did not then obviously your system had failed! RUN AWAY!

Testing:
Now suppose you are the risk-averse type(and yet you choose to trade...). A prudent move for such a cautious trader would be to test your hypothesis. You saw all the indicators in your system pointing to a BUY. What should you do? The logical step would be to plunge head first into a buy position and expect the price to increase soon. But the prudent trader will do this:
  • Take a small position first. Say, about 30% of what you originally wanted to use. So if you had wanted to trade an amount of $20,000, you take a position with $7,000 first.
  • Wait for your position to turn positive. Then add to your position as the price indeed moved in the direction as you predicted. If not, wait for your cutloss to be triggered.
Now you have risked only 30% of your initial capital and benefited fully if your system was correct. Of course, the more confirmation you need(ie. the more the price moves up), the less gains you will make because you waited till the price increased before taking the position fully. It is like the uncertainty principle in theoretical physics: the more certain you are of a particle's position, the less certain you are of its speed. The more certain you are that your are right, the less gains you will make.

I hope this has been helpful to you.
=)


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